When the markets are heading south, instead of selling, what you may really want is a hedge.
You should consider the implications that come with trading in inverse ETFs and carefully monitor and rebalance those ETFs to maintain a market hedge as a way to reduce volatility of returns, write Joanne Hill and Solomon Teller for IndexUniverse.
By adding negatively correlated investments to your portfolio, or in this case ETFs that move in the opposite direction, you will help offset changes in value of a target position.
Inverse ETFs provide an inverse multiple – usually, -1x, -2x or -3x – of the daily return of a benchmark. These funds provide a negative correlation to an index without having to short securities, are traded on exchanges like stocks and are priced throughout the day.
Leveraged -2x ETF strategies tend provide more volatile returns and are riskier than the simple -1x ETFs. Investors will have to rebalance more often when trading during choppy market conditions. [New Leveraged ETNs for Long-Term Investors.]
Hill and Teller list a few factors worth considering:
- Choosing a benchmark. Index-based hedges are usually more liquid, easier to monitor, trade and rebalance over time.
- How much? How much risk you want to reduce will depend on the magnitude of a hedge, with the maximum 100% full hedge against a long position. Investors typically hedge 10% to 20% to help reduce volatility in returns.
- Selection. Try to consider a hedging vehicle’s return profile, effectiveness, expected duration of a hedge, liquidity, cost, financing and ease of trade.
- Monitor and rebalance. Portfolios with active risk may outperform or underperform a benchmark over time, so you should periodically rebalance. Often, investors rebalance on a monthly basis, quarterly basis or at fixed-percentage changes. We have rebalancing alerts available on our site at intervals you determine.
Consider Hill and Teller’s points (and read the entire article; it’s full of great information), the head over to the ETF Analyzer to find, sort and track the whole universe of leveraged ETFs.
For more information on leveraged ETFs, visit our long-short ETFs category.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.