From punting to protection: Short & leveraged ETFs emerge as hedging tools

Conventional wisdom holds that short and leveraged ETFs exist to facilitate directional betting by aggressive speculators.

According to a new academic study, however, these products are outgrowing their retail roots and finding increasing employment as risk management tools for sophisticated investors.

In a recent paper titled Short Selling Index ETFs and Market Performance, professors Doina Chichernea, Alex Petkevich and Kainan Wang found that high levels of shorting through US broad market ETFs were typically followed by a period of positive index performance – a relationship more consistent with hedging than betting on market direction.

The finding was “surprising”, said Wainan Kang, professor at the University of Toledo. “In the short interest literature, people usually find that if short interest goes up then future returns go down. Short sellers tend to be skilled investors with a sense of where the market will go.“So if you believed that US equity index ETFs were being shorted for speculative purposes, you would expect high short interest to be followed by a period of negative performance. We saw the opposite.”

While the study includes both generic index ETFs and leveraged and inverse products, the relationship was stronger when investors established their short exposure using the latter – in other words, going short a leveraged long ETF or long an inverse ETF – an insight that runs counter to general perception.

Douglas Younes, CEO of $51bn US short and leveraged ETF provider Direxion, said his firm’s products are being increasingly used as risk management tools by sophisticated investors. He highlighted two common use cases.
The first was from retail clients, often looked after by financial advisors, wanting to reduce their exposure to richly valued US equities without generating a tax bill. Buying an inverse ETF offsets the corresponding long exposure without having to sell any assets sitting on large capital gains.

The second was from market makers looking to hedge their trading positions. These firms “find our ETFs a clean and efficient source of leverage: they don’t have to trade as many securities and can quickly move out of them in order to clean up their hedge books,” Younes explained.

Although issuers have long pitched short and leveraged products as convenient risk management tools, they have never quite managed to shake their reputation as a convenient outlet for retail punting.

Indeed, their growing popularity is often associated with speculative froth – a sign that the US stock market is in the final throes of an epic bubble. Short and leveraged ETFs currently house around $147bn in assets under management globally, according to figures from ETF Action, almost double what they held in 2017.

For Gianmarco Roncarolo, director at issuer GraniteShares, short and leveraged products “are evolving beyond their reputation as speculative instruments: they’re becoming part of the broader toolkit for experienced investors and portfolio managers looking to manage risk dynamically.”

While GraniteShares’ products remain widely used by retail investors as vehicles for directional exposure, a “relevant” share of flows comes from sophisticated investors looking to hedge their long exposure to US equities, Roncarolo told ETF Stream.

Although the paper itself does not disaggregate between investor types, a previous study by Wang found that over half of short and leveraged ETF assets are held and traded by institutional investors – a number that will come as a surprise to many.

In Europe, where the market is smaller and less mature, penetration among professional investors is likely to be lower.

“Usage remains overwhelmingly DIY investor-driven, with market makers providing liquidity but not using them as hedges,” said Oktay Kavrak, communications & strategy director at Leverage Shares, Europe’s leading short and leveraged player.

“The data reflects this: although we’ve had the most traded ETP in London three years running, the average ticket size in our range is a few thousand pounds – a fraction of what you see in plain-vanilla ETFs.”

There are signs that change is afoot, however. “As the market grows in Europe, our products are getting more interest and traction from professional investors as tools for portfolio risk management. We’re seeing it on the ground,” said GraniteShares’ Roncarolo.