Equity Portfolio Hedging Using the ProShares Short S&P 500 ETF

While I’m not a proponent of a stock market crash in a context where the economic recovery remains on track and unemployment numbers have fallen to their lowest level since February 2020, I certainly have in mind that the highest inflation reading in nearly 40 years has increased the likelihood of stock market volatility occurring in 2022.

In this scenario, limiting risk to financial assets in the form of a hedging strategy is important, especially when investors have patiently built their portfolios over the years and wish to remain invested in equities. In this regard, there are many ways to hedge, including treasury bonds and commodity ETFs as well as derivatives, such as options and futures.

In this thesis, I consider a hedging tool that involves taking an opposite position to a related asset that worked during two of the most recent stock market crashes, namely the Great Financial Crisis of 2008-2009 and the downturn associated with the Covid of 2020. This tool is the ProShares Short S&P 500 ETF (SH) and it inversely tracks the broader stock market or the S&P 500. For investors, it is important to test its effectiveness and show how it actually works using the SPDR S&P 500 ETF (TO SPY).

Testing the effectiveness of SH in providing inverse market correlation

When SPY, which faithfully replicates the gains or losses of the S&P 500, plunged more than 45% from 2008 to 2009, the ProShares fund, on the contrary, managed to gain more than 30%. This is illustrated in the table below. Subsequently, when SPY lost 50% from January to March 2020, SH gained 25%. Both of these events are illustrated in the chart below and show the ability of the market short tool to provide an inverse correlation to the broader market.

Source: commercial view

Continuing further, some of you would have noticed that the returns of SH are not -1x or the exact inverse of SPY. The reason for this discrepancy is due to the compounding effect which has a negative impact on the performance of leveraged ETFs like SH, where returns are significantly different from the target return for periods that exceed one day. That’s why ProShares fund managers to advise investors to monitor holdings frequently, preferably daily.

To be more specific, the things to watch are the performance of SPY itself, which, if in a consistent uptrend, has the potential to conversely cause a significant decline in SH’s stock price and, in turn, reduce the gains that are expected to be made when market short selling does not. proceed as planned. In the same vein, lack of oversight will certainly lead to capital losses, as evidenced by the downtrend of SH (blue chart) since its inception in 2007 of nearly minus 90% (-90%). So, unlike SPY which is a long-term investment, SH is a market shorting tool that allows investors to take advantage of a decline without having to reduce their stock portfolio. This explanation would be incomplete without seeing hedging in action using an example portfolio.

Illustrate how hedging works with an example portfolio

For illustrative purposes, I consider a $10,000 equity investment made through SPY stock. This could be part of a 70/30 portfolio, with 70% equities and 30% fixed income.

The first scenario (Scenario 1) which is not covered resulted in a loss of $4,500 during the great financial crash of 2008-2009, with SPY losing 45% on a $10,000 investment. Then, the second scenario describes the same period but, this time with the application of a hedge in the form of a $1,000 investment in SH, or 10% of the equity portfolio. As a result, $9,000 was invested in SPY and the losses were reduced to $3,750. This excludes ProShares’ expense ratio of 0.88%, which is only $8.8 on a $1,000 investment. Ultimately, this shows that hedging using the ProShares ETF actually works. Now, the percentage at which a portfolio is hedged can vary, with 5% and 15% hedges being quite common.

Source: Prepared by the author.

Continuing further, I have provided two more scenarios for an unhedged and hedged portfolio respectively and this time relating to the March 2020 stock market crash. Again, even after excluding ProShares fees which are minimal, hedging, in As a damage limitation mechanism, it works, but it is essential to monitor performance during the short market period. For this question, it is necessary to have an “optimal time” to enter and exit a position in SH in order to capture the “best case” impact of hedging.

On a note of caution, keep in mind that historical performance is no guarantee of future success and each time is a different hedging scenario.

Finally, given the high inflation with a CPI greater than 7% and the CBOE S&P 500 Volatility Index (VIX) fluctuating between 19 and 20, the risk factors are there.

Disclosure: This is an investment thesis and is intended for informational purposes. Investors are urged to do further research before investing.

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About Meredith Campagna

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