Double and double-inverse ETFs can be useful tools for portfolio management.
I received an email recently from a reader who asked about hedging a portfolio, specifically using HXD, which is the Horizons BetaPro S&P/TSX 60 Bear Plus Fund (TSX: T.HXD, Stock Forum). What a mouthful! For those who are not familiar with double and double-inverse ETFs, essentially they provide 200% of the daily performance of an underlying index, which in this case is the S&P/TSX 60 index.
The regular Bull ETF will return 2% when the S&P/TSX60 is up 1%, and will return -2% when the index is down 1%.
The bear version gives you 200% of the inverse daily performance so if the S&P/TSX is up 1%, the Bear ETF is DOWN 2%. If the index is down 1%, the Bear ETF is UP 2%.
Here is the original question:
I wonder if you would consider a column on the ins and outs of using a hedge (notional or formal) to reduce investment risk. A concrete example might be based on a primary investment in the TSX index with a hedge using the Horizon S&P TSX Bear Plus ETF (TSX: T.HXD, Stock Forum)). When is it a hedge and when is it diversification? How much is enough? etc.
Hedging is the complete opposite of speculation. Another way to put it is that speculation is the taking on of risk in the hopes of a higher reward, and hedging is the elimination of risk and the elimination of higher potential rewards. The two are diametrically opposed.
Let's assume that our test investor invests in XIU – which is the iShares ETF (TSX: T.XIU, Stock Forum) that tracks the S&P/TSX60 index. In order to completely hedge the portfolio (reduce all risk), he would need to hold one-third of his portfolio in HXD (the double-inverse ETF that tracks the same underlying index). While he was doing this, his portfolio will be a flat line (actually it will be a slightly negative line over time as the MERs of each ETF will create a small drag on the portfolio). If he only wanted to reduce a portion of the volatility he could use smaller amounts of HXD. The graph below shows the effects of different levels of hedging.
You can see that holding 33% HXD (line in red) completely removes risk from the portfolio and completely removes all returns as well. This is a perfect hedge. By using smaller percentages of HXD you can reduce the level of volatility (and corresponding returns) as much as you want.
So when would you hedge? Clearly from above, it would make sense that long-term investors would not need to hedge their portfolios on a constant basis. If the goal is to reduce volatility ONLY, then as a long-term investor you would look for other investments that had similar return expectations and low or negative correlation to your existing assets. That is diversification and it is different from hedging specifically because you are only trying to reduce volatility, not returns (hedging does both).
Over long periods of time I don't believe you should be employing a constant hedge. However, if we flip the graph so that XIU were to lose 10% over the course of the same time period, the whole graph flips upside down and you will instantly see the benefits of hedging!
If we take a look at the second peak of the blue line (unhedged portfolio) we see that if someone picked this point to invest (not knowing he or she was investing at a top), they would have lost less with a hedge. So to answer your question – people hedge when they think there is bad news pending. The catch is, how would you ever know for sure? And if you REALLY knew, why wouldn't you just sell your investments and wait out the storm?
Well, there are other factors as well. If you had held XIU for years and have a large unrealized capital gain, you could add a hedge to keep your portfolio from losing value, while not triggering a gain on your entire portfolio. Once you thought the rough patch was over, you could remove the hedge. You would have a capital gain on the hedge (in this case), but it would be less than realizing a long, built-up capital gain of the overall portfolio – especially if you were planning on reinvesting after you thought the period of volatility was over.
Indeed, double and double-inverse ETFs can be quite useful tools for portfolio management.
