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I wrote recently that timed-hedging was a good solution to protect a dividend portfolio. Sophisticated investors may prefer hedging with options, but for most people ETFs are an easier way. My previous article (read here) gave the example of a dividend portfolio hedged by a short position in SPY when the aggregate EPS estimate of S&P 500 companies for the current year is below its value 3 months ago. This solution is neither perfect, nor unique. You can choose a different hedging ratio and a different timing indicator. You have also various ETFs to short the S&P 500. The first table lists the most liquid ones.

Ticker

ETF Type

Position*

Size/stock portfolio*

SPY

Long 1x

Sell Short

100%

SH

Short 1x

Buy

100%

SSO

Long 2x

Sell Short

50%

SDS

Short 2x

Buy

50%

UPRO

Long 3x

Sell Short

33.3%

SPXU

Short 3x

Buy

33.3%

* To hedge a portfolio against the S&P 500 index in a 1:1 ratio

Except SPY, no ETF in the list was available before 2006. With a database providing synthetic data for these ETFs, calculated from the index variations since 1999, I could simulate two hedging tactics:

- Permanent hedging, holding the position all the time.

- Timed hedging when the market is "fundamentally bearish" according to the EPS-based indicator described in my previous article.

There are better timing indicators, I have chosen a simple one for the demonstration. In my simulation, the indicator is checked once a week. For an individual investor, it is more realistic than everyday.

Here are the total returns between 1/2/1999 and 10/17/2013:

Ticker

Permanent hedging

Timed hedging

SPY

-73.2%

48.9%

SH

-62.7%

34.7%

SSO

-60.6%

66.6%

SDS

-63.6%

38.7%

UPRO

-55.68%

80.2%

SPXU

-60.6%

49.5%

They take into account a 0.1% rate for transaction costs.

Since 1999, timing the market with our simple indicator brings a profit instead of a cost on the hedging position - a profit that can be reinvested. SPY is the best known ETF, but not the best for this purpose because its dividend is accounted negatively when holding a short position. UPRO and SSO give the highest returns, for both the permanent and timed hedging. However, the borrowing cost to sell short UPRO is 4.4% a year at my broker, and 3.2% for SSO. In the timed hedging version, the position is held a cumulative time of about 4 years, which destroys most of the additional return and increases the risk. Indeed, the borrowing rates are not constant and the future hedging time ratio is unknown. Moreover, there is always a risk for shorted shares to be called back by the broker for any reason (it happened to me once with a very liquid ETF).

As a result, taking a long position in SPXU becomes the best solution for the return, a lower margin, and a lower carry cost. You may be wary of the natural decay of leveraged ETFs (beta-slippage). In fact, beta-slippage is close to zero on S&P 500 derivatives and it may even become positive in trending periods. At the opposite, the borrowing rates for leveraging and short selling will probably go up with all interest rates.

If you don't have a margin account, timed hedging is still possible. You can sell 25% of your portfolio when the indicator triggers a bearish signal, and buy SPXU. Then, you are in the case of the last line of both tables: one third of the stock value in a 3x inverse ETF. It has been profitable since 1999, without speaking of the volatility and drawdown reduction reported in my previous article.

Source: The Best Way To Hedge Your Portfolio With Leveraged ETFs