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Using Leveraged ETFs to Hedge Equity Portfolios

|Includes:Vanguard Total Bond Market ETF (BND), DBC, SDS, SH, SHY, SPY, SSO, VEU, VNQ, VTI
I recently wrote an article on 4 Methods to Hedge an Equity Portfolio.  A reader asked how leveraged ETFs would perform as a hedge in lieu of single (1x) short ETFs.  I should preface that I typically do not use leveraged ETFs and they carry additional risks including added volatility and the potential for tracking error. Please do not use leveraged ETFs unless you fully understand the product and the risks involved.

Two of the four methods from my first article can be tested using leveraged ETFs.

Relative Strength

 Assume we hold a portfolio of 5 ETFs - BND (bonds), DBC (commodities), VEU (international equities), VNQ (REITs), VTI (US equities), which represent 5 major asset classes.  A buy and hold portfolio since 2008 had 22.4% volatility and a -46.28% drawdown  (despite being allocated across 5 seemingly diverse asset classes) and, frankly, disappointing results (results from ETF Replay include dividends, the chart below has been updated to include this week's returns so may differ slightly from the first article):

Next, I created a leveraged portfolio of SSO (Proshares 2x leveraged long S&P 500), SDS (Proshares 2x leveraged short S&P 500), and SHY (short-term treasuries, used as a close proxy for cash).  I went long whichever of the three had the highest combined ranking as determined by the highest relative strength over the past 3 months and 20 days, and lowest volatility over the past 20 days.  The system rebalanced semi-monthly, produced the following results. Volatility was  extremely high, which is to be expected when only holding  leveraged positions:

As in the first article, we can test returns if  an investor held 50% of a portfolio in the 5 ETF portfolio referenced above and allocated the other 50% to the leveraged strategy.  I used a 50% allocation to both strategies for simplicity and not as a recommended allocation. The strategy returns and volatility are below, slightly better than the returns of the 1x short leveraged strategy but at much higher volatility:

Market Conditions

Another hedging strategy is to based long/short positions on overall market conditions.  There are a myriad number of ways to gauge "market conditions" and how one hedges these "conditions" depends on your time-frame and current portfolio.  However, assume we hold a portfolio of US equities or US equity ETFs and wish to hedge them during "unfavorable" market conditions. 

Stockscreen123 has devised a timing system using 2 factors to determine "market conditions":

 It assumes conditions are favorable for equity investing if EPS estimates are rising and if valuations are reasonable.
  1. The estimates test is whether the 5-week moving average of the aggregate of the consensus current-year estimates for S&P 500 companies is above the 21-week moving average.
  1. The valuation test is based upon risk premium, specifically, whether the S&P 500 risk premium (earnings yield minus 10-year treasury yield) is above 1%
For the leveraged system, when conditions are "favorable", one would be long equities via SSO  and during unfavorable conditions, short equities via SDS.  Re-balancing every 4 weeks for 5 years results in the following equity curve (red line)  compared to the S&P 500 (blue line) and overall returns of 481%:

During periods of high volatility and market drawdowns, this system performed well, moving inversely to the S&P 500.  It is still a high-risk system, in my opinion, with periods of high volatility and under-performance. Consider, for example, the 2 year returns, which exclude the large market decline of 2008 and early 2009 that contributed significantly to the high 5 year returns of the system:

It is important to note these tests are not comprehensive and it is difficult to draw long-term or broad based conclusions from them. Leveraged ETFs can be used as a hedge but their effectiveness and risk vs reward, especially in terms of higher volatility, should be studied and considered carefully by investors on an individual basis.

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