I received an email a few days ago from a reader who asked about hedging a portfolio, specifically using HXD which is the Horizons BetaPro S&P/TSX 60 Bear Plus Fund. 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. (Click here to read a more in-depth description I wrote a while back)
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 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 email:
I enjoy your blog and 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(HXD). Or bonds. Or ishares XIN. Or …? 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 that tracks the S&P/TSX60 index. In order to completely hedge the portfolio (reduce all risk), he would need to hold 1/3 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 the effects of different levels of hedging.
You can see that holding 33% HXD 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. 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).
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Why would you ever hedge? At every point in time, the 100% XIU portfolio is higher than any of the other hedged portfolios, which just seems to indicate to me that you are losing out on returns, and there doesn’t appear to be any advantage at all.
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!
Or, take a peak from XIU. Imagine you picked that time to invest $100,000. If XIU decreases in value, all the other portfolio decrease LESS (look at the slopes).
So to answer your question – people hedge when they thing 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?
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.
How would this differ from just holding less XIU to begin with? HXD is just negating a portion of our XUI position so why not just buy less XIU?
@James – Good question and I would agree that it would be better to just hold less XIU if initiating a position. However, if you have a large unrealized gain and did not want to trigger it this would be one way to do it assuming you had cash to invest. Secondly, as noted in my previous comment, I don’t think it makes sense to hedge on a continuous basis in most cases. For those who want to try to time the markets for short periods of time, this is one mechanism to do that. Thanks for the question!
Hi,
Great article! How did you get to the answer that you need 1/3 of the portfolio in HXD? What’s the formula?
And what if the portfolio consists of different stocks (and not just the XIU), what % of HXD would need to hedge?
Thanks.
This article shows little understanding of the dynamics of double up/down funds. While the hedge may work on a 1-day period, the discussion assumes this will continue to work over time. However, the embedded optionality of the ETF will result in a hedge mismatch after market movements occur. For example, if the market experiences volatility but ends up at the same level as it started, the XIU portion will retain its value while the ETF portion will have declined in value.