Once used primarily as a substitute to mutual fundsexchange-traded funds (ETFs) can now help investors accomplish several different financial objectives: to invest across sectors, to participate in niche markets, and to allocate money across asset classes like stocks, bonds, currencies, real estate, and commodities.

Versatility means that ETFs appeal to all sizes and stripes, allowing investors to make bullish or bearish bets, or even to hedge a portfolio for safety. In this article, we'll look at a few strategies with exchange-traded funds that can protect or hedge investor portfolios from different types of risk.

Benefits of Hedging With ETFs

Hedging has historically been limited to the use of derivative-based securities like futures, options, and over-the-counter securities. Because the mechanics of the pricing of the derivative-based securities are based on advanced mathematical formulas, like Black-Scholes options pricing models, hedging has mostly been domain to large, sophisticated investors.

Key Takeaways

  • Exchange-traded funds can be used for hedging purposes.
  • One strategy is to buy inverse S&P 500 ETFs, which move opposite to the stock market.
  • Some exchange traded funds track the performance of the dollar against other currencies, which offer opportunities to hedge exchange rate risk.
  • Buying shares of ETFs that hold commodities, like gold or natural resources, can be a way to hedge against inflation.

The ability to purchase and sell small increments of ETFs appeals to smaller investors who previously had limited access to hedging due to the larger minimum requirements associated with traditional protective strategies. In fact, there are a number of ways individual investors can use ETFs to hedge portfolios today.

Stock Market Hedging

Investors often use futures and options to hedge their positions in stocks and bonds. One of the most common and actively traded tools for the equity market, for example, are S&P 500 Index futures, which are used widely by large institutions, including pension funds, mutual funds, and active traders.

ETFs like ProShares Short S&P 500 (SH) and ProShares UltraPro Short S&P 500 (SPXU) move inversely to the S&P 500 Index and can be used in lieu of futures contracts to take short positions in the general stock market, making these positions simpler, cheaper, and more liquid.

Some inverse ETFs are leveraged and will be more volatile than the overall market because the funds are designed to move two times or three times more (the inverse) than the overall market.

While the mechanics of using short equity ETFs are much different than using futures and matching the hedged positions are not precise, buying a short ETF provides easy access as a means to the end. That is, the share price of the inverse fund will increase in value if the stock market falls, and the increase in value can help offset losses suffered by stocks within the portfolio.

Hedging With Currencies

Just like with equity market hedging, before the wide acceptance of ETFs, the only way to hedge a non-U.S. investment was to use currency forward contracts, options, or futures. Forward contracts are rarely available to individual investors, as they are often agreements between large entities that are traded over-the-counter.

Like interest rate swaps, forward contracts allow one party to assume the risk of a long position and the other party to assume a short position in a currency to liken their particular needs to hedging or betting. By design, the participants rarely take physical delivery of the currency position and choose to cash out the ending value based on the closing currency exchange rate. During the life of the forward contract, no money is exchanged, and the valuation is typically based on the appreciation/depreciation of the swap or held at cost.

Smaller investors can attempt to hedge exchange rate risk of long non-U.S. investments by purchasing corresponding amounts of funds that take a short U.S. dollar position, such as the Invesco DB U.S. Dollar Bearish (UDN). On the flip side, an investor who is based outside of the United States can invest in shares of funds like Invesco DB U.S. Dollar Bullish (UUP) to take a long U.S. dollar position to hedge portfolios from exchange rate irks.

ETFs that track the performance of the dollar—such as PowerShares Bullish Dollar Fund—are designed to replicate the performance of the buck against a basket of other major currencies and, for that reason, will not effectively hedge the exchange rate risk associated with any single currency.

Just like substituting futures and options in the equity and bond market, the levels of accuracy when matching the portfolio's value to the hedged position is up to the investor. But thanks to the liquidity of ETFs and the fact that (unlike options and futures) ETFs never expire, investors can easily make adjustments, as needed.

Inflation Hedging

Inflation hedging with ETFs hedges against an unknown and unpredictable force. While inflation has ranged in small bands historically, it can easily swing up or down during normal or abnormal economic cycles.

Many investors seek out commodities as a form of hedging against higher inflation based on the theory that if inflation rises or is expected to rise, so will the price of commodities. In theory, while inflation is rising, other asset classes like stocks may not be rising, and investors can participate in the growth of commodities investments.

While gold and other commodities have historically moved higher along with inflation, the relationship is not exact, and other factors—such as changes in supply and demand—will impact commodities prices as well.

There are hundreds of ETFs to access precious metals, natural resources, and just about any commodity that can be traded on a traditional exchange. Examples include the U.S. Oil Fund (USO) and the SPDR Gold Trust (GLD). There are also broad commodity ETFs like Invesco DB Commodity Tracking (DBC).

The Bottom Line

The benefits of using an ETF for hedging are numerous. First and foremost is cost-effectiveness, as ETFs allow investors to take positions with little or no entrance fees (commissions). In addition, since shares trade like stocks, the process of buying and selling is a straightforward process for most individual investors. Lastly, ETFs cover many markets, including stocks, bonds, and commodities.