An ETF Strategy to Stay Invested in Equities and Hedge Downside Risks

Exchange traded fund investors can consider a strategy to incorporate a hedged equity position into a portfolio as a way to mitigate tail risk while seeking upside market participation.

In the recent webcast, Reduce Market Downside Risk with a New Approach to Hedge Equity Portfolios, Jamie Atkinson, Managing Director, Head of Global Sales, Swan Global Investments, noted that investors have traditionally turned to fixed income assets like Treasuries to hedge market risk and balance out a diversified investment portfolio. However, he warned that the future seems bleak for fixed income assets as we are already in a near-zero interest rate environment, with low yields and limited appreciation potential. For example, investors would need $160 invested in 10-year Treasuries to produce $1 of income if benchmark 10-year Treasury note yields remain at these record low levels. In comparison, investors would have only needed about $15 invested to generate $1 of income when 10-year yields were back above 8% in 1990.

Atkinson pointed out that investors have had to adapt to this new lower-for-longer rate environment by turning to cash, structured products, and gold as safe-haven plays. On the other hand, investors have become more aggressive, raised stock allocations, chased momentum technology winners, turned to speculative-grade bonds, and bought speculative bets like crypto in search of higher returns.

Consequently, Atkinson argued that investors need some kind of hedge that addresses left tail risks like market crisis, Covid-19, large loss, and a long recovery process while simultaneously tackling right tail risks like under-allocation to equities and missing out on potential returns.

As a way to maintain equity market exposure with some downside protection, Marc Odo, Client Portfolio Manager, Swan Global Investments, highlighted Swan Capital Investment’s new launch, the Swan Hedged Equity U.S. Large-Cap ETF (HEGD).

“Our innovative Always Invested, Always Hedged philosophy is executed in a 3-step process,” Odo said. “The result is a distinct blend of passive investing and active risk management.”

Specifically, the Swan Hedged Equity U.S. Large-Cap ETF is always passively invested in S&P 500 Index ETFs, and it hedges against this equity-side risk through actively managed long term put options purchased at or near-the-money to mitigate risks of bear markets. Finally, HEGD has actively managed option trades utilizing a disciplined, time-tested approach as a means to generate additional return to offset the cost of the hedge.

HEGD uses Long-term Equity Anticipation, or LEAP, option contracts that expire at least one year from the date of purchase. The long term hedge is used because it may last longer than bear markets, may not be under duress to re-hedge during crisis, and may provide the opportunity to acquire more shares of underlying equity ETF during major market sell-offs. The hedge is also rolled annually so that the portfolio is always hedged.

Odo also argued that HEGD may serve different objectives for different investor types. For example, it may help increase return potential while maintaining a similar risk target for traditional allocation. The strategy can help shift cash off the sidelines and remain invested to increase market exposure. Finally, the ETF can help re-allocate to equity positions as a means of mitigating downside risk or volatility, while maintaining a level of equity upside participation.

Financial advisors who are interested in learning more about risk management strategies can watch the webcast here on demand.