Inverse and leveraged ETFs have the reputation of being hazardous instruments to invest in. We don’t disagree with this view but would like to take a closer look at using these instruments as a hedge against market risk.
How Do Inverse Leveraged ETFs Work?
An inverse ETF aims to produce a return opposite to the index it tracks. As an example, an inverse ETF on the S&P 500 should rise, when the index falls, and vice versa. Inverse ETFs often have names containing ‘bear’ or ‘short.’
A leveraged ETFs aim to produce returns of a multiple of the index it tracks. A 2x leveraged ETF on the S&P 500 should move by twice the return of the index. Leveraged ETFs often have names containing ‘ultra’ or ‘pro.’
Putting these two concepts together, an inverse leveraged ETF moves in the opposite direction, and with an amplified magnitude of the underlying index. Let’s have a look at what conceptually happens behind the scenes of such a product:
- we put $10,000 into a 3x leveraged inverse ETF of an index, which is currently trading at 100
- the ETF collects our $10,000 and sells 300 shares of the index, resulting in 3x inverse leverage
- the ETF now holds $40,000 in cash, which it can invest in the money market
- within a day, the index moves from 100 down to 95, and the ETF posts a profit of 300 x 5 = $1,500
- exposure to the index is now 300 x 95 = $28,500, while it needs to be 3 x $11,500 = $34,500 in order to maintain the 3x leverage
- the ETF resets, and sells 63 additional shares of the index, for a total of 34,500 / 95 = 363 short shares
Without the reset in the last step, the ETF would fail to deliver the promised 3x leverage continuously. However, this reset is also the reason why we achieve the 3x inverse relationship only over periods of single days, but not for longer periods such as a week or a month. We call this behavior path dependency.
It is important to understand the implications of this path dependency before using leveraged products. Let’s assume the index snaps back to 100 on the next day. Our investment in the 3x Bear ETF will now post a loss of 363 x 5 = $1,815. Over two days, we are experiencing a net loss of $315, while the index remained flat.
Performance of a 3x Bear ETF
Let’s look at a chart, to gain a more natural feeling for the performance of a 3x Bear ETF. As a representative for this product category, we chose SPXU, ProShares UltraPro S&P 500 Bear 3x ETF:
We can see that over the observed period, the S&P 500 rose at an annual rate of about 12%. Over the same period, our 3x Bear ETF fell at an annual rate of 41%. Given that the S&P 500 has a long term upwards trend, it is clear that such a product is not suitable for long term investment. We can use it for other purposes, however.
Taxation of Investments
In a classic (passive) 60/40 portfolio, our stock portion grows virtually tax-deferred: while we hold on to the stocks, there are no taxable events, and thus our capital gains are deferred until we sell the shares. The bond portion is a different animal though: the total return of bonds is dominated by interest paid, which is taxed the same year at the regular income tax rate. For more details on taxation, please see our prior post.
At Bertram Solutions, we advocate actively managed portfolios, because we believe that active management allows better control of risk. Portfolio risk is dominated by exposure to the stock market, which implies that we need to vary stock market exposure over time. The classic method of adjusting stock market exposure is to trade the stock portion actively. As outlined above, we will face undesirable tax consequences when doing so.
Hedging with an Inverse Leveraged ETF
Using an inverse leveraged ETF, we can adjust market exposure without buying and selling stocks. Here is how that works:
- 60% of our assets we invest in stocks. Except for occasional rebalancing, we don’t alter this position, thus avoiding taxable events: our stock portion grows tax-deferred
- 40% of assets, we manage actively. We do not suffer any negative consequences from doing so, as interest earned from bonds is taxed the same way as short-term capital gains
- Using a quantitative indicator, we determine our target exposure to the stock market. In times of economic stress, we hold up to 15% in a 3x leveraged inverse ETF, allowing us to counteract up to 45% of exposure to the stock market
- The remaining assets we invested in bonds. This portion is now variable between 25% and 40%
To determine our target exposure to the stock market, we can use a combination of technical analysis and macro-economic indicators, as described in a previous post. As this indicator creates only very few signals, we need to simulate the behavior over an extended period, containing at least one recession. Unfortunately, typical inverse ETFs were only introduced after the Great Recession of 2008. We can simulate the results of our strategy nonetheless: knowing the underlying mechanics of an inverse ETF, we can create synthetic data closely tracking the performance of available ETFs. We have written another blog post, showing how we extend data into the past. Here is the result:
As we can see, for the longest time, our hedged portfolio behaves precisely like a passive 60/40. This makes sense, as the portfolio holdings are identical over those periods. In times of recession, we see our downside significantly reduced through holding the inverse leveraged ETF. Also, as shown above, we have been able to do so, without incurring negative tax consequences.
Now that we have reduced our portfolio downside, it is time to re-visit the original portfolio allocation. Most likely, we based our decision to allocate 60% toward stocks on the maximum drawdowns during the 2008 recession. Following that logic, we might want to increase our stock allocation now, and rely on active hedging to keep drawdowns within our comfort zone. That way, we can participate more in the stock market, and typically increase our average returns. As an example, we could go with a 75/25 allocation:
As we can see, the maximum drawdowns of the hedged 75/25 portfolio still compare favorably to a passive 60/40 portfolio. However, we have also increased our return in bullish years.
We summarize this approach to portfolio management in 3 steps:
- reduce risk – through active management
- increase return – by increasing stock participation
- minimize taxation – by using smart hedging techniques
We very much hope this post provided valuable insight into hedging techniques with inverse leveraged ETFs. At Bertram Solutions, we pride ourselves in doing independent research, and this post is a good example of our approach to analyzing investments.