Exchange Traded Funds (ETFs) as an investment basket come with some unique features that make them an ideal avenue for hedging an existing equity or a multi-asset-class portfolio. The key attribute is a defined set of rules that determine the composition of an ETF or the underlying index. ETFs, therefore, fall into any of the parameters that define market sectors or asset classes. For example, banking sector ETF, gold ETF, or the more exotic re-weighted broad market ETF and foreign ETF.
Characteristics Of A Hedge
Before we get into the characteristics of a hedge we must first define what a hedge is. Investopedia defines a hedge thus: Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security.
This forms a simple hedge where an investor takes an offsetting position in a derivative contract. However, given the complexity and leveraging effect of derivatives, these are not suitable for all investors. A better approach to portfolio hedging would be to use a correlation based hedge, in instruments (like ETFs), which the investor is comfortable with.
Unlike a normal investment objective, the importance of a hedge is simply to protect against downside risk. This can be achieved by using weakly correlated assets or some that are weakly/negatively correlated. An example of this kind of hedging is to use investment portfolios from different geographies like India and the US. The long term and intermediate term correlation between the Indian large-cap index, the Nifty, and the growth NASDAQ-100 Index is between .25 to .27 depending on the exchange rate used and interpolation techniques to align the two data sets.
An Example
A sample portfolio is constructed by taking an equal proportion of the NIFTY (via any Nifty ETF) and using a NASDAQ-100 ETF such as MOSt Shares NASDAQ 100. The portfolio is denominated in Indian Rupees, hence, is not a currency hedged investment. The portfolio is rebalanced exactly once every year to equalise the proportion of the Nifty and NASDAQ-100.
As the weak correlation comes into play and the two indices, being high growth, do not move up or down in tandem, the volatility that the investor is subjected to gets reduced. This, in turn, reduces the draw downs (except in extreme market conditions like the bursting of the tech bubble in the early naughties). The rebalancing has the precise effect of profit booking, thereby preventing downside risk post a high-growth period. In the simulation that was run for the above example, for the 15-year period from February 1995 to February 2011, the Nifty gave annualised returns of 11.7%, the NASDAQ-100 returned 14.7% and the sample portfolio returned about 15.5% and that too at lower volatility.
Conclusion
While this example looks at two indices, ETFs can be used to hedge any actively managed, stock selection portfolio. Additionally, using some of the commodity/metals ETFs, inflation (which has a direct bearing on commodity prices) can be hedged. Interest rate positions can be managed by using fixed income or money market portfolios.
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