If you are an investor looking to reduce risk in a volatile market, consider hedging strategies with ETFs. Hedging protects your portfolio from adverse price movements by taking an opposite position in another asset.
ETFs, or exchange-traded funds, are collections of securities that track an index, sector, commodity, or theme. They offer low-cost, diversified, and liquid exposure to various markets. Let’s explore what hedging strategies with ETFs are, how they work, and some of the best strategies to protect your portfolio. We will also provide examples to illustrate how they can reduce risk and enhance returns.
Hedging strategies with ETFs involve using ETFs to offset the risk of another investment. For example, if you own a portfolio of stocks sensitive to the US economy, you might hedge against a possible recession by buying an ETF that tracks US Treasury bonds. If the stock market declines due to a recession, the bond ETF should rise in value, cushioning your losses.
Hedging strategies with ETFs can be classified into two types: passive and active.
Passive hedging strategies involve buying and holding an ETF that has a negative correlation with your portfolio. This means the ETF tends to move in the opposite direction of your portfolio. For example, if you own a portfolio of technology stocks, you might buy an ETF that tracks gold, a safe-haven asset during uncertainty.
Active hedging strategies involve adjusting your exposure to an ETF based on your market outlook and risk tolerance. You can increase or decrease the size of your hedge depending on your confidence in your portfolio. For example, if you own a portfolio of emerging market stocks, you might buy an ETF that tracks the US dollar, which tends to appreciate when emerging markets face challenges. You can reduce your exposure to the dollar ETF when you expect emerging markets to recover.
Hedging strategies with ETFs work by balancing your portfolio and the ETF used as a hedge. The goal is to reduce overall volatility and risk without sacrificing too much potential return. To achieve this, consider three factors: correlation, beta, and hedge ratio.
Correlation measures how closely two assets move together. It ranges from -1 to 1:
Ideally, use an ETF with a negative correlation to your portfolio as a hedge.
Beta measures how sensitive an asset is to movements of another asset. It is calculated by dividing the covariance between the two assets by the variance of the other asset. For example, if an ETF has a beta of 0.5 relative to your portfolio, it moves 0.5% for every 1% movement in your portfolio. Use an ETF with a low beta relative to your portfolio as a hedge.
Hedge ratio is the proportion of your portfolio you want to hedge with an ETF. It is calculated by multiplying the beta of the ETF by the value of your portfolio and dividing by the value of the ETF. For example, if you have a $10,000 portfolio with a beta of 1 relative to an ETF worth $100 with a beta of 0.5, your hedge ratio would be (0.5 x 10,000) / 100 = 50%. This means you need to buy 50 shares of the ETF to hedge 50% of your portfolio.
Here are some of the best hedging strategies with ETFs to consider:
Inflation erodes the purchasing power of money and reduces the real value of your investments. To hedge against inflation, use ETFs that track commodities like gold, silver, oil, or agricultural products. These ETFs rise in value when inflation increases. Alternatively, use ETFs that track inflation-protected securities like Treasury Inflation-Protected Securities (TIPS).
Interest rate risk affects the value of bonds and other fixed-income securities. When interest rates rise, bond prices fall. Hedge against this risk using ETFs that track inverse or short-term bonds like ProShares Short 20+ Year Treasury ETF (TBF) or iShares 1-3 Year Treasury Bond ETF (SHY).
Currency risk affects the value of foreign investments and earnings due to changes in exchange rates. When the US dollar weakens, foreign investments become more valuable in dollar terms. Hedge against currency risk using ETFs that track foreign currencies like Invesco CurrencyShares Euro Trust (FXE) or WisdomTree Japanese Yen Strategy Fund (JYF).
Market risk involves losing money due to changes in market conditions. Hedge against market risk using ETFs that track inverse or alternative assets like ProShares Short S&P500 ETF (SH) or Amplify BlackSwan Growth & Treasury Core ETF (SWAN).
To illustrate how hedging strategies with ETFs work, let’s look at two examples:
Example 1:
You have a $10,000 portfolio of US stocks with a beta of 1 relative to the S&P 500 index. You want to hedge 50% of your portfolio against a market downturn using an inverse S&P 500 ETF worth $50 with a beta of -1. Your hedge ratio would be (-1 x 10,000) / 50 = -200%. You need to buy 200 shares of the inverse S&P 500 ETF to hedge 50% of your portfolio. If the S&P 500 index drops by 10%, your portfolio loses $1,000, but your hedge gains $1,000, resulting in a net loss of $0.
Example 2:
You have a $10,000 investment in a European company paying dividends in euros. You want to hedge 100% of your investment against a US dollar appreciation using a euro ETF worth $100 with a beta of 1 relative to the euro/US dollar exchange rate. Your hedge ratio would be (1 x 10,000) / 100 = 100%. You need to buy 100 shares of the euro ETF to hedge 100% of your investment. If the euro/US dollar exchange rate drops by 10%, your investment loses $1,000, but your hedge gains $1,000, resulting in a net loss of $0.
Hedging strategies with ETFs provide a practical way to protect your portfolio from market volatility. By understanding and implementing these strategies, you can reduce risk and enhance returns. Consider your investment goals, risk tolerance, and market outlook when choosing the best hedging strategies for your needs.
A: Hedging with ETFs offers diversification, liquidity, and cost-efficiency. It helps reduce portfolio risk and manage market volatility effectively.
A: Yes, beginners can use hedging strategies with ETFs. Start with simple strategies and gradually explore more complex ones as you gain experience.
A: Choose an ETF that has a negative correlation or low beta relative to your portfolio. Consider the ETF’s performance, fees, and market conditions.
A: Yes, hedging with ETFs involves risks such as tracking errors, market risk, and potential costs. It’s essential to understand these risks and manage them effectively.
A: Regularly review your hedging strategy, especially during market changes or when your investment goals shift. Adjust your hedges as needed to align with your objectives.
A: Passive hedging involves holding an ETF with a negative correlation to your portfolio, while active hedging adjusts ETF exposure based on market outlook and risk tolerance.
A: Yes, you can hedge against various risks such as inflation, interest rate, currency, and market risk using different ETFs tailored to each risk type.
A: Calculate the hedge ratio by multiplying the ETF’s beta by the value of your portfolio and dividing it by the value of the ETF.
Ready to explore hedging strategies with ETFs? Find out more on our ETFs Trading page. Visit VT Markets for information on FX Trading and more.
