A Diversified, All Hedged ETF Portfolio

|
Includes: DBEF, DBEM, HYHG, IGHG, VQT
by: Brad Kenagy

Summary

I construct a portfolio composed entirely of ETFs built in hedges.

The asset classes the portfolio consists of are: US, Developed Markets, and Emerging Markets Stocks. Investment grade and High Yield bonds.

The three types of risks hedged in my portfolio are: Market Risk, Currency Risk, and Interest Rate Risk.

In this article, I will be constructing a portfolio made entirely of hedged ETFs for different asset classes. I will be hedging three areas of risk: Market risk, Currency risk, and Interest rate risk. The asset classes I will be including in the portfolio are US stocks, developed market stocks, emerging markets stock, investment grade corporate bonds, and high yield corporate bonds.

US Stocks

For this selection, I chose to use the Barclays ETN+ VEQTOR S&P 500 Linked ETN (NYSEARCA:VQT) because of its dynamic allocation to stocks, volatility and cash. What makes VQT a good option to hedge is it has a built-in volatility hedge that allows the fund to increase its exposure to the VIX and cash, when the market is selling off. The following chart from the VQT fact sheet shows how historically the fund has been allocated. What you can see on the chart is there was a big spike in the allocation to Volatility in August 2011, which coincided with the large market decline caused by threat of default for the United States.

The second chart below shows the performance of VQT compared to the S&P 500 (NYSEARCA:SPY) for 2011, and it is clear that the exposure to the VIX during times of extreme volatility increased the performance greatly. With the feature of being able to dynamically allocate to the VIX and cash during periods of market crisis, VQT seemed like a quality choice for my ETF to choose for US Stocks. In addition, for those that do not like ETNs, there is an ETF that tracks the same index that VQT does. That ETF is the PowerShares S&P 500 Downside Hedged Portfolio ETF (NYSEARCA:PHDG).

Click to enlarge

Click to enlarge

Developed Market Stocks

For this selection, I chose the db X-trackers MSCI EAFE Hedged Equity ETF (NYSEARCA:DBEF). The reason I chose this ETF was it provided an allocation to developed market equities with currency risk hedged out from owning those equities. In addition to being long equities in the EAFE index, just like in the iShares MSCI EAFE ETF (NYSEARCA:EFA), DBEF adds a currency hedge by going long the US Dollar, and shorting the currencies where the fund has an allocation. The following chart from the DBEF holdings page shows that the ETF is short 12 developed market currencies to hedge out the risk of owning stocks in a foreign currency.

Emerging Markets Stocks

For this selection, I chose the db X-trackers MSCI Emerging Markets Hedged Equity ETF (NYSEARCA:DBEM). The reason I chose this ETF was it provided an allocation to Emerging markets equities with currency risk hedged out from owning those equities. The ETF adds a currency hedge by going long the US Dollar, and shorting the currencies where the fund has an allocation. The following chart from the DBEM holdings page shows that the ETF is short 22 emerging markets currencies to hedge out the risk of owning stocks in a foreign currency.

Investment Grade Corporate Bonds

For this selection, I chose the ProShares Investment Grade-Interest Rate Hedged ETF (BATS:IGHG). IGHG is long investment grade corporate bonds, and has an average maturity of 14.74 years, which carries high interest rate risk with a maturity that long. However, IGHG adds a hedge by shorting US treasuries, the effect of this is that IGHG has an effective duration of -0.03 years, which means the fund is interest rate risk neutral. The trade off though for the hedge is that if interest rates fall as they have done this year, IGHG will fall in value since it is short US treasuries. IGHG, I believe, is a good way to hedge interest rate risk brought on by a rising interest rates.

High Yield Bonds

For this selection, I chose the ProShares High Yield-Interest Rate Hedged ETF (BATS:HYHG). HYHG is long high yield corporate bonds, and has an average maturity of 6.65 years. HYHG adds a hedge by shorting US treasuries, the effect of this is that HYHG has an effective duration of 0.16 years, which means the fund is slightly above the level of being interest rate risk neutral. Just like IGHG, HYHG will fall in value since it is short US treasuries. HYHG, I believe, is a good way to hedge interest rate risk brought on by rising interest rates.

Portfolio Performance

The chart below shows the total return of a portfolio consisting of equal weighted positions in each of the 5 hedged ETFs I chose, compared to an equal weighted portfolio of un-hedged ETFs from the same asset categories as I focused on in this article. The ETFs in the un-hedged portfolio are listed in the table below. The chart below shows the comparison between the hedged portfolio, and the un-hedged portfolio starting on November 13th 2013, which was the first day of trading for IGHG. While this is not a lot of data, the chart paints a clear picture of how the hedged portfolio has performed during the last 9 months. As you can see, the hedged portfolio has underperformed the un-hedged portfolio by a margin of 2-1. I expected that outcome for a couple reasons; the first was that since VQT has its dynamic allocation to the VIX and cash, returns have lagged the S&P 500 because volatility has remained low. In addition, each hedged bond ETF has underperformed because interest rates have fallen which has lowered the returns of each fund since they are short US treasuries.

SPY

SPDR S&P 500 Trust ETF

EFA

iShares MSCI EAFE ETF

(NYSEARCA:EEM)

iShares MSCI Emerging Markets ETF

(NYSEARCA:LQD)

iShares iBoxx $ Investment Grade Corporate Bond ETF

(NYSEARCA:HYG)

iShares iBoxx $ High Yield Corporate Bond ETF

Click to enlarge

Click to enlarge

Closing Thoughts

In closing, I believe the portfolio I have created would be good option for someone who is looking to hedge multiple types of risks in the equities, and the fixed income space. The portfolio has underperformed because both the stock market and the treasury market have moved against the hedges the ETFs have, however, if the stock market has a large correction and/or interest rates spike higher, the hedged portfolio should outperform the un-hedged portfolio.

Disclaimer

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.