Hedging With Single Inverse ETFs Part II: Tactical Strategy For Downside Protection

In the first part of this article (Hedging with Single Inverse ETFs: Opportunities vs Risks), we noted that investing in inverse ETFs can be riskier relative to their non-inverse counterparts. Indeed, it has been well documented that holding these investments over longer horizons expose investors to serious losses. A quick overview of publications available online shows a disproportionate number of studies against the use of these vehicles as Buy & Hold over longer terms. Regulatory Authorities continue to urge manufacturers on their roles and responsibilities, especially in the matter of full disclosure to investors when launching these investments. Though, the bulk of research discourage the use of these products over the long run, few do acknowledge their suitability in the very short term.

We also explained in part I that inverse ETFs come in different forms. Some are Single Inverse that theoretically provide 1 to 1 opposite return of the underlying benchmark. Others are multiple inverse ETFs (or leveraged); for example, they may provide 2 to 1 or 3 to 1 inverse return of the underlying benchmark. Then, we showed that the multiple inverse ETFs are more likely to drift substantially from their underlying index over longer terms. The single Inverse ETF on the other hand, appears to minimize tracking error even over longer horizons. Hence, the excessive negative sentiment pertains more to leveraged multiple Inverse ETFs as they exhibit a higher propensity for quick value depletion. The Single Inverse ETF on the contrary, presents some compelling opportunity for hedging over medium terms. Its utilization is very straightforward compared to traditional hedging vehicles such as options, future or swaps.

In this article we will illustrate a basic strategy with two components. The first component is long a concentrated portfolio of stocks as a Buy and Hold, while the second one is short a Single Inverse ETF. Ideally the long side should hold few above average beta stocks with a high conviction for growth. In addition to growth, higher quality dividend yield would be another key characteristic; this would help offset the return erosion that the Single Inverse ETF creates over the course of the investment horizon. Most of the work focuses on the short side as the long component is passively held. Holding the Single Inverse ETF as Buy and Hold has proven to erode lesser value than leveraged ones, although still not recommended. Therefore, a tactical strategy that shifts the Single Inverse ETF out of markets in favorable risk environment would be worthier.

The strategy runs from January 2017 till October 28 2022, covering a period of almost 6 years. The long side holds three stocks in three different sectors: HD (Home Depot, Consumer Discretionary), MSFT (Microsoft, Technology) and BAC (Bank of America, Financials) while the short side holds only the Single Inverse ETF (in this instance SH, ProShares Short S&P500 that provides the daily Single Inverse return of SP 500). It is important to note that the long side could have been any other stocks that meet our aforementioned criteria. This backtest focuses on the short side and seeks primarily to illustrate that the Singe Inverse ETF can valuably substitute traditional bear markets hedging instruments such as bonds, options, future or swaps.

A tactical approach of holding SH versus Buy & Hold would reduce performance erosion as compared to holding SH as Buy & Hold. That tactical decision becomes essentially an assessment of risk on/risk off environments. The VIX or the so called “fear index” is one of the popular Wall Street tools for making such assessment, although empirical studies are not conclusive of its superiority over the realized volatility (see Asness: Please Stop Talking About the VIX So Much). Another way for gauging risk on/risk off situations is to compare an index price to its moving average over a certain period of time. If the current price is more than the moving average, it’s risk on thus a Buy signal. Otherwise, it’s risk off or a Sell. For the purpose of this article, we will use a combination of price momentum and realized volatility to determine when to hold SH vs S&P 500 (In this instance SPY). Going long SPY is usually during period of lower volatility and higher price momentum. On the other hand, going short coincides with higher volatility and lower momentum. The strategy takes the opposite of trading SPY. In essence, it holds SH tactically (short SPY) if the current volatility is more than its trailing 120 days average in addition to the current price being lower than its moving average over the same period of time. Otherwise, it exists SH and is only long HD, MSFT and BAC. The higher volatility signals a risk off environment, hence a need for hedging.

As a first test for evaluating if holding SH tactically (Tactical.SH) rather than as a Buy & Hold (Buy.And.Hold.SH) is a viable strategy, we contrast the performance of Tactical.SH versus Buy.And.Hold.SH along with the underlying index SPY (Fig 1).

The above figure shows that over most of the entire period, a tactical exposure to SH with entries and exits, depletes lesser value than simply buying and holding SH.

Armed with the evidence that a tactical approach of holding SH appears to add value, let’s explore how this can protect the long side the portfolio in bear markets. As described earlier, the long component of the portfolio is a Buy & Hold of three stocks (HD, MSFT and BAC). When unhedged the portfolio is fully invested into these three stocks equally. When hedged, 80% is allocated to the three stocks equally while the remainder 20% is allocated to SH, the latter with some tactical views and not as Buy & Hold. We also create a custom balanced 60/40 portfolio for comparison where 60% is equally invested into HD, MSFT, BAC, while 40% is allocated the fixed income (AGG, iShares Core US Aggregate Bond ETF).

In Fig 2, we can observe that holding the three stocks as simple Buy & Hold with no hedge results to greater absolute returns than hedging 20% of the portfolio with SH. The Buy & Hold also outperforms a balanced 60% equally in HD, MSFT, BAC and 40% in AGG. However, that outperformance comes with greater volatility than the 20% hedged portfolio or the balanced 60/40 as previously defined. Table 1 below provides further insight into the true performance of the three portfolios in terms of Sharpe ratios or risk adjusted returns and betas. It confirms that the hedged portfolio and balanced 60/40 provide smoother ride with higher Sharpe ratios than the Buy & Hold along with lower betas.

On a particular note, the 20% Hedged portfolio and the Balanced 60/40 appear very competitive although the former outperformed with a better Sharpe ratio. The higher risk adjusted return of the hedged portfolio versus the 60/40 leads to few remarks. First, the plausible superiority of a Single Inverse ETF for downside risk protection versus fixed income in some cases. Second, the type of protection provided by a Single Inverse ETF in bear markets versus fixed income. To better understand this, we will compare the cumulative returns of Tactical.SH to AGG (bonds) in three different negative periods: Q4 2018, Q1 2020 and Year to date till October 28 2022 (Fig3 panels A,B,C and Table 2). In all periods, Tactical.SH outperformed AGG which is not a surprised as SPY was negative and its reverse return was delivered by Tactical.SH. In 2022 particularly, while the Tactical.SH was positive due to prolonged bear market, AGG was negative for the most part on the backdrop of higher inflation and rates. The effectiveness of Tactical.SH over AGG in bear markets warrants its due consideration as a hedging tool for prolonged downside markets. Bonds such as AGG sometimes fail to live up to their hedging characteristic with a positive return when equities are negative, because both asset classes share some common risk factors. For instance, in 2022 the two asset classes have been under pressure due to higher inflation and rates. Conversely the Single Inverse ETF during the same period has been positive. Though its underlying index (SPY) is also affected by these risk factors, the Single Inverse ETF simply matches on a daily basis 1x reverse return of the underlying albeit not dollar for dollar. Thus, the Single Inverse ETF helps insulate against risk factors that affect equities and bonds. It also behaves differently and more effectively than bonds in some bear markets situations, which explains its outperformance in 2022.

Fig 3

Panel A

Panel B

Panel C

Conclusion

The blackest of a long passive portfolio hedged by SH revealed the opportunity of using SH tactically to manage downside risks rather than bonds or other hedging vehicles such as options or futures. In most cases, hedging with Inverse ETFs can lead to disastrous performance over longer horizons as outlined in part I of this article. However, investors need to make a clear distinction between the type of inverse ETFs. The Single Inverse ETF as opposed to its multiple Inverse counterparts, appears to offer adequate hedging capabilities over medium terms. Holding it tactically for few weeks or months can reduce the performance drag and protect the long side of a portfolio in bear markets. In retrospect, 2022 provided a great macro environment for hedging with SH tactically. In comparison, bonds likewise equities fell a lot short due to common risk factors such as rising inflation and interest rates. Hence, a Single Inverse ETFs can be considered as a more effective tool than bonds for managing medium to long term risks in some market environments. In addition, it offers an opportunity for hedging with no margin requirement in accounts, unlike traditional hedging instruments like options or futures.