Once primarily used as a mutual fund substitute, exchange-traded funds (ETFs) have expanded far beyond the realm of passively investing in managed funds. They are now used to invest in asset classes like stocks, bonds, currencies, real estate and commodities, and across sectors and in niche markets. Their versatility means they appeal to investors of all sizes and stripes, allowing them to make bullish or bearish bets, or even to hedge a portfolio for safety. In this article, we'll look at how ETFs can be used for hedging.

Benefits of Hedging With ETFs

Hedging has historically been limited to the use of derivative-based securities like futures, options, forward contracts, swaptions, and various combinations of over-the-counter and exchange-traded securities. Because the mechanics of the pricing of the derivative-based securities are based on advanced mathematical formulas like Black-Scholes options pricing models, they have generally been used by large, sophisticated investors. ETFs, however, are as simple to trade as stocks. And because they trade like stocks, ETFs come with comparatively low transaction and holding costs compared to the costs of futures, options and forwards. The ability to purchase and sell hedging components in small increments with ETFs appeals to smaller investors who previously had limited access to hedging due to the larger minimum requirements of traditional hedging strategies.

There are a number of ways ETFs can be used to hedge.

Stock Market Hedging

Investors typically use futures and options on the stock and bond market to hedge their positions or take short-term placements to enter or exit the market. One of the most common and actively traded tools for the equity market are S&P 500 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) 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. While the mechanics of using short equity ETFs are a little different than using futures and matching the hedged positions may not be as precise, this strategy provides easy access as a means to the end. The position can also be unwound when needed - unlike futures contracts, which expire regularly, requiring investors to cash out, take delivery, or re-hedge when the contract matures.

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, and futures. Forward contracts are rarely available to individual investors, as they are often agreements between large entities that are traded over the counter. Also, they are typically held to maturity. Like interest rate swaps, they 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 easily hedge long non-U.S. investments by purchasing corresponding amounts of funds that take a short U.S. dollar position, such as the Invesco DB US 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 US Dollar Bullish (UUP) to take a long U.S. dollar position to hedge against their portfolios. 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 their lack of maturity dates, investors can easily make minor adjustments.

Inflation Hedging

So far, we have covered hedging portfolios in a traditional sense, offsetting variable risks or maintaining market positions. Inflation hedging with ETFs encompasses similar concepts but 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 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. There are hundreds of ETFs to access precious metals, natural resources, and just about any commodity that can be traded on a traditional exchange. 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 small investors to take positions with little or no entrance fees. They typically have very low holding/management fees compared to the total costs of physical delivery or commissions on futures and options. They also provide access to markets (like the currencies market) that would not be cost-effective for individual investors, as well as liquidity beyond the levels found in futures and options, lower bid/ask spreads, and the ability to trade openly in stock exchanges. ETF hedging creates additional liquidity in markets, allowing for better "look through" transparency and eliminates the counterparty risk associated with over-the-counter contracts between two parties.