ETFs offer a simple, effective, diversified, low-cost way of investing. But as they typically track broad indices, when the markets are down across the board, so are your investments. With many investors becoming increasingly concerned about risks such as inflation and volatility, hedged ETF funds could offer investors the chance to hedge against losses or even make money in challenging markets.

So, what is hedging? How does hedging work with an ETF? Can you hedge against inflation with an ETF? What are the benefits of hedging with ETF funds? What’s the downside or risk of hedging?

Let’s dive in.

What is hedging?

Hedging is a technique that every investor should be aware of to help manage risk. 

Hedging is a strategy to offset losses in one investment by taking an opposing position in a related asset. Whilst this typically results in lower portfolio growth, it can help to reduce risk and volatility. You can think of it as a form of insurance to help soften the blow if an event negatively affects your main investments.

Hedging is typically used to involve complex financial instruments called derivatives. You may have heard of options and futures. These are two of the most common derivatives. However, because these instruments are complex, calculating prices generally remained the domain of large institutional investors who have the knowledge and algorithms at their disposal.

But in recent years a slew of new ETF funds have become available to smaller investors, meaning that it is now possible to hedge using ETFs.

How does ETF hedging work?

Let’s say you hold a large position in an ETF that tracks the S&P 500 but you are concerned that the markets might tank and you want to protect your position. You could take a smaller position in an ETF that shorts the S&P 500 and therefore moves in the opposite direction. Applying an ETF hedge to take a short position instead of a futures contract is simpler, cheaper, and more liquid.

Or perhaps you are concerned about excessive volatility. You could choose to invest in a low volatility ETF which selects stocks that have demonstrated the most stable performance.

Or you could choose a more sophisticated long/short ETF which attempts to mimic a typical hedge fund strategy with a mix of long and short positions. In a bull market, this type of ETF will never realise the same gains as a pure long ETF, but can reduce losses or even turn a profit in a bear market.

Can you hedge against inflation with an ETF? 

If there’s one risk that has many investors rattled at the moment is inflation. With US inflation reaching a 13-year high of 5.4% in September 2021 it’s easy to see why. Increased retail prices effectively eat into your portfolio by eroding the spending power of your money.

So is there an ETF inflation hedge strategy that you can use?

Many investors turn to commodities such as natural resources or precious metals such as gold as a hedge against inflation. Whilst there isn’t a proven link, commodity prices have historically tended to increase in times of higher inflation. 

If you want to hedge against inflation using ETFs, there are plenty available that track individual commodities, or broad ETFs that follow the whole commodities market. There are also ETFs intended to hedge against inflation by combining not only commodities but also other assets such as Treasury Inflation-Protected Securities, real estate, and inflation-sensitive stocks.

What are the benefits of hedging with ETF funds?

Compared to other hedging techniques involving derivatives such as options or futures, hedging with an ETF is a simple and more liquid as they can be bought or sold as you would any stock or ETF. The costs are lower due to smaller fees, and the ability to purchase and sell small increments of ETFs. Compared to derivatives, an ETF hedge may also reduce downside exposure if your worries prove to be unfounded and the markets edge higher.

What are the downsides or risks of hedging?

Although the costs of hedged ETFs are likely to be lower than derivatives, they are likely to be significantly higher than the expense ratios of simple long ETFs. The higher expense ratios of short ETFs will tend to reduce any potential gains and increase losses.

Hedging requires a deeper understanding of financial principles and access to more detailed information than simply following a buy-and-hold strategy. Without this knowledge and data, you will not be able to make an informed decision about how much to hedge and what instruments to use.

Perhaps the biggest risk is that although the markets may experience tough times, in the long run, they always trend higher. Although hedging may temporarily reduce losses, holding onto a hedge position for too long may significantly harm your long-term returns or even end up resulting in losses. The solution to this is to assess when to buy a hedge position and when to sell it, but that requires you effectively time the market. 

Takeaways

Hedging is a well-established financial practice that investors use to reduce portfolio losses in case the market experiences a downturn. Whilst hedging with ETFs is cheaper and simpler than hedging using derivatives, for many investors without the required level of knowledge, it can prove to be riskier than simply buying and holding.

If you’re looking for a simple way to manage your investments at an appropriate risk level tailored to your own personal tolerance and financial goals, you may find that a Roboadvisor such as ETFMatic offers a cost-effective solution.