A Hedge is a Hedge, is a Hedge, is a…

To any Prince fans out there, yes, I’m paraphrasing the Purple One’s lyric from “Pope”. I thought it would be appropriate given today’s topic. Any guesses? Okay, let’s go.

Hedging can mean a lot of different things to different people. As with anything investment related, it helps to understand what event or series of events you are trying to either take advantage of or, in this case, hedge against. In other words, once you understand the job at hand, you can pick the right tool for the job. The good thing (and bad thing) about this industry is that there are a ton of tools out there to help investors manage risk. Good because of the variety of tools, bad because it can get confusing trying to figure out what tool to use, especially if you’re not 100% sure what you’re trying to hedge against except “losing money.”

Of Black Swans and Boiling Frogs

Given QTD (to 4/15/2024) broad market returns that range from -2.92% (Invesco QQQ Trust: QQQ) to -6.90% (iShares Russell 2000 ETF: IWM) it looks like markets are starting to roll over. When you throw in the other signals that have been flashing like unusually high 10-year treasury yields, record high gold prices (2,383.51 as of 4/15/2024), and VIX at 18.90 (up 43% YTD / 45% QTD), some are getting a feeling that something negative is going to be happening sooner than later. The good news in this is that while there have been a few sharp shocks, markets have absorbed them without completely falling out of bed. We have seen a couple of 1%+ down days recently but nothing free fall. My take is that we are going to see the market grind lower through the next quarter, go sideways through the election, and see the Fed start cutting before the end of the year.

Depending on your point of view, you may say that having a balanced asset allocation is an appropriate hedge because investing is all about relative performance, or that your time horizon is long enough that you’ll just dollar cost average your way through any potential unpleasantness. To some investors, the idea of a hedge is something they use so that they don’t get hurt as much by a downturn as they would without it. Another perspective is that you may not have the kind of time needed to let markets recover from any upcoming trough to the next peak, or that you don’t have enough funds to facilitate a steady stream of recurring investments. What are your alternatives then?

In ETF land, there are a couple of ways to hedge against this scenario. One is by investing in Defined Outcome products like those offered by Innovator, First Trust, and others, and the other is by investing in inverse exposure funds like those offered by Direxion and ProShares.

Know What You Own

Defined outcome ETFs are essentially packaged vertical spread trades with a one-year expiration. If what you just read sounds like gibberish, a vertical spread is a multi-contract (leg) option strategy that provides a range of returns restrained by upper and lower underlying prices. Innovator was the first to bring these products to market and they are structured so that investors get synthetic exposure which is effective exposure to the underlying using option contracts and not holding equities or another ETF (say the S&P 500). Potential downside is limited (from 9% to 35%) and upside is capped at levels determined at the time the fund starts trading. The amount of upside cap depends on exactly which contracts are used to complete overall fund holdings. Each fund has a one-year expiration which is something to keep in mind when evaluating a fund. The stated buffers for these products are fully achievable if the fund is purchased on its launch date and held through expiration. What happens is that market action moves the value of the underlying, and in turn, impacts the value of the options held in the fund. In other words, say there is a 9% buffer fund that launched 5 months ago and the markets have dropped 12% since the launch. That buffer has been fully used. In fact, when you look at the product table for these fund types, one of the metrics they display is how much buffer is remaining in the fund, as well as how much potential upside is still achievable. So, if you do decide to utilize these products, pay attention to how much buffer is still available!

Leveraged ETFs have been around for about 15 years and have served investors well, as long as they have understood what these products are meant to do and how they work. These funds are essentially swaps inside an ETF structure, or “wrapper” as the industry likes to say. A swap is an agreement between two parties where one promises to pay a fixed stream of income and the other promises to pay a variable stream of income. What ends up happening is that instead of each party paying the full amount to each other, they simply exchange any net difference. These evaluations, known as the “mark to market” and payments occur daily. The daily part is important because these products are designed to guarantee the stated leverage of the fund over a one-day trading period. What happens when these funds are held for more than a single trading period is that you end up getting a crash course on “Path Dependency.” Each fund prospectus has a great section that clearly spells out that increased day-to-day volatility in a fund’s underlying exposure can lead to results that diverge increasingly from expectations. If you really want to go down a rabbit hole here, check out this 2009 paper from some researchers at NYU. This effect becomes more pronounced with higher rates of leverage. For example, SPY has returned 22.00% (price return only) for the past year (4/14/2023 to 4/15/2024) while SPDN (Direxion Daily S&P 500 Bear 1X Shares) returned -17.61%, SPUU (2X Bull) 39.87% and SPXL (3X Bull) made 58.77%. Now you may notice that these returns kind of line up with the stated leverage but remember that the past year hasn’t seen highly volatile periods like we did only a few years ago. The same comparison from 12/31/2019 through 12/31/2020 has SPY gaining 16.16%, SPDN (1X Bear) losing 24.56%, SPUU (2X Bull) rising just 12.31% and SPXL (3X Bull) coming in only 9.34% higher.

Now What?

While we all are acutely aware of what won the late, great, Daniel Kahneman his Nobel Prize (that we humans hate losing more than we like winning) I’m hoping that this brief introduction to some potentially powerful hedging tools can help you better manage risk without putting everything in what I sometimes refer to as “The Mattress Fund.” Remember to pay attention to the remaining buffer and also, If you decide to go the inverse exposure route, pay attention to volatility, which is good advice in general if I say so myself.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.