The stock market offers an exciting opportunity to build your wealth. However, it’s also a system that’s fueled by volatility, exposing its participants to market risks. If you’ve paid attention to the market for any significant period of time, chances are you remember a time when significant declines happened across the board.
The most recent of these events took place as the COVID-19 pandemic took hold in 2020. Many investors experienced short-term losses that amounted to significant percentages of their portfolios, and there was almost no warning.
Events like these are why investors — especially large-scale investors like investment banks and accredited investors — often take part in a practice known as hedging. However, the rise of exchange-traded funds (ETFs) has simplified the process for the average investor as well, meaning that you too can hedge your portfolio like big-money players do to protect your wealth from significant downturns.
How to Hedge Your Portfolio With ETFs
Hedging a portfolio is an investment strategy that’s centered around balancing investments with other investments that will counteract their results. For example, if a stock is purchased in hopes of gains ahead, a put option may be purchased at the same time with a strategically chosen strike price and expiration date. If the stock purchase goes bad, the put option becomes profitable and offsets the losses.
Because hedging uses derivatives and complex equations in their pricing, historically the strategy was used only when making larger investments. Today that’s changing thanks to ETFs.
When exchange-traded funds first hit the tape, they acted as alternatives to mutual funds, with diversification at their cores, and did a great job of serving that purpose. As these funds became more popular, more options became available.
Today, ETFs provide easy access to a wide array of assets, ranging from equities to corporate bonds, currencies, and much more. Regardless of your investment objectives, there’s an ETF that will help you meet them.
It’s no surprise that investors have begun using these funds as tools to hedge their portfolios. Depending on the makeup of your portfolio, here’s how you’d use ETFs to hedge your portfolio:
Originally, stock hedging tools were limited to derivatives like options and futures contracts, with their pricing based on intense mathematical equations. Unfortunately, that meant only investors with a deep understanding of the market and quite a bit of money to throw around took part in the process.
With the availability of various types of ETFs today, that’s no longer the case.
One of the most common ways the average investor can hedge against the risk of sudden stock declines is through inverse ETFs, also commonly called short-equity ETFs. These funds use derivative investments to mimic the result of taking out short positions. So when equities fall in value, inverse ETFs based on those equities rise.
Of course, it’s important to do your research and choose your investments wisely because fund performance and expense ratios will vary wildly from one ETF to the next. Nonetheless, the vast majority of these funds result in similar returns to short selling, with fees that pale in comparison to what short sellers pay.
For an example of how to use an inverse ETF to hedge your portfolio, let’s say you own an S&P 500 index fund and want some protection against declines in the market.
In this case, you could buy shares in the ProShares UltraPro Short S&P500 (SPXU), a leveraged inverse ETF. This fund aims to produce three times the direct opposite result of the S&P 500. So if the S&P rises 1%, the SPXU declines 3%. On the other hand, if the S&P falls 1%, the SPXU rises 3%.
As a result, a small investment in the SPXU could make a world of difference in offsetting potential losses from investments in the S&P 500. But keep in mind that your SPXU shares will lose value if the S&P rises, offsetting some of your gains as well.
Inflation should always be a consideration for investors, more so today than in recent memory. With prolonged low interest rates from the Federal Reserve, increasing wages, and supply scarcity hitting the United States economy in waves, inflation is on the rise.
Ultimately, the Fed will most likely raise interest rates to bring inflation back down, but until it does, this phenomenon will present significant portfolio risks.
One of the best ways to hedge against inflation is to buy assets that gain value with the rising prices. For example, gold is known as a strong hedge against inflation because, historically, as prices have risen across the board, gold prices have risen as well.
But owning physical gold coins or bullion can be burdensome. Careful storage considerations are a must, and there’s always the risk of theft.
The good news is that there are plenty of gold ETFs on the market today. Not only can you find funds that provide exposure to the precious metal itself, but you can also invest in ETFs that own the mining companies that produce it.
Some of the most popular gold ETFs include:
- SPDR Gold MiniShares Trust (GLDM)
- Aberdeen Standard Physical Gold Shares ETF (SGOL)
- GraniteShares Gold Trust (BAR)
Exchange-rate risk is a concern for a wide range of entities. Businesses that operate overseas often require a hedge against the risk that the currencies in the regions in which they operate fall in value compared to the U.S. dollar. This is also the case for investors in international equities and international currencies.
One of the best ways for U.S. dollar-based traders to hedge against exchange-rate risks is to purchase an ETF that bets against the U.S. dollar. However, there is a caveat — according to ETF.com, there’s only one such fund: the Invesco DB US Dollar Index Bearish Fund (UDN).
By contrast, investors outside the U.S. exchanging their currencies for U.S. dollars could hedge against exchange-rate risk by using the Invesco DB US Dollar Index Bullish Fund (UUP).
Asset Class Hedging
Asset class hedging, more commonly known as asset allocation, is a must in any investment portfolio. By spreading your investments across a wide variety of assets, you’ll protect yourself from the risk of any single asset in your portfolio taking a nosedive.
The most common asset classes to consider include equities, fixed-income securities, and commodities.
ETFs have made asset allocation very simple. There are countless funds centered around stocks, bonds, and commodities. You don’t have to choose the best investments in each category anymore. All you need to do is decide what percentage of your portfolio should go to each category and choose a few funds that represent those assets.
Benefits of Hedging Your Portfolio With ETFs
There are several benefits to hedging in general. Doing so properly has the potential to expand your portfolio’s total return by providing protection from downside risks.
There are also added benefits involved when you decide to use ETFs as a means to hedging. The most significant of these added benefits include:
- Low Cost. ETFs are the low-cost darlings of the stock market. Although expenses are higher on inverse funds than on traditional funds, ETF expense ratios are generally far lower than the fees you would pay to trade the assets within the portfolios the funds represent.
- Tax Efficiency. ETFs come with tax efficiencies. Buying and holding an ETF involves fewer taxable events than most other forms of investing. Moreover, because investments in ETFs are generally held for a long time, investors enjoy long-term capital gains rates, which are lower than standard income tax rates.
- Simplicity. When you buy ETFs, you need not decide which individual assets you should invest in. Instead, the hard work of investment decision-making is left to the professionals.
Regardless of what market conditions are taking place at the moment, it’s always wise to have at least some hedging going on in your portfolio. Even in the best of markets, surprises take place often, and having investments that gain when others feel the pain will shield you from the blow when they do.
Thankfully, ETFs have made the hedging process pretty simple.
Nonetheless, it’s important to take the time to do your research before diving into any investment, even exchange-traded funds. After all, each fund will have its own historic performance, fees, and asset allocation. You’ll want to make sure the funds you choose fit in with your investment objectives.