Portfolio Hedging in Action Using the ProShares Short S&P 500 ETF

While I am no advocate of a market crash in a context where the economic recovery remains on track and unemployment numbers have dropped to their lowest since February 2020, I certainly have in mind that the highest inflation reading in nearly 40 years has raised the probability of occurrence of stock market volatility in 2022.

In this scenario, risk limitation to financial assets in the form of a hedging strategy is important, especially when investors have patiently built their portfolio over the years, and want to remain invested in equities. In this respect, there are many ways to hedge including treasury bonds and commodities ETF as well as derivatives, such as options and futures contracts.

In this thesis, I consider a hedging tool that involves taking an opposite position to a related asset and which worked during two of the most recent market crashes, namely the 2008-2009 great financial crisis and the 2020 Covid-related downturn. 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 efficacy and show how it actually works using the SPDR S&P 500 ETF (SPY).

Testing SH’s efficacy to provide inverse market correlation

When SPY which straightly replicates the gains or losses of the S&P 500 plunged by more than 45% from 2008 to 2009, the ProShares fund conversely managed to gain more than 30%. This is shown in the chart below. Subsequently, when SPY lost 50% from Jan to March 2020, SH gained 25%. These two events are illustrated in the chart below and show the ability of the market shorting tool to provide inverse correlation to the broader market.

Source: Trading View

Pursuing further, some of you would have noticed that SH’s returns are not -1x or exactly the inverse of SPY. The reason for this discrepancy is due to the compounding effect which adversely impacts the performance of leveraged ETFs like SH, whereby the returns are significantly different than the target return for periods that exceed one day. It is for this reason that the fund managers at ProShares advise investors to monitor holdings frequently, preferably on a daily basis.

Being more specific, items to monitor are the performance of SPY itself, which if on a consistent uptrend has the potential to inversely cause a significant downside in SH’s share price, and by ricochet trim the gains one expects to obtain when shorting the market does not proceed as expected. Along the same lines, failure to monitor will certainly result in capital losses as evidenced by SH’s downtrend (blue chart) since inception in 2007 by nearly minus 90% (-90%). Thus, contrarily to SPY which is a long-term investment, SH is a market shorting tool that enables investors to benefit from a downturn without having to trim down their equity portfolio. This explanation would be incomplete without seeing hedging in action using a sample portfolio.

Illustrating how hedging works with a sample portfolio

For illustration purposes, I consider a $10,000 investment in equities made through shares of the SPY. This could form part of a 70/30 portfolio, with 70% equity and 30% fixed income.

The first scenario (scenario 1) which is un-hedged entailed a loss of $4,500 during the 2008-2009 great financial crash as SPY lost 45% on an investment of $10K. Next, the second scenario depicts the same time period but, this time with the application of a hedge in the form of a $1000 investment in SH, or 10% of the equities portfolio. As a result, $9000 was invested in SPY and the losses were reduced to $3,750.This excludes ProShares’ expense ratio of 0.88%, which make up for 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 author.

Pursuing further, I have provided two other scenarios for an un-hedged and hedged portfolio respectively and this time pertaining to the March 2020 market crash. Again, even after excluding ProShares’ fees which is minimal, hedging, as a damage limitation mechanism works, but, it is essential to monitor the performance for the period the market is shorted. For this matter, there is the need for “optimum timing” for entering and exiting a position in SH in order to capture the “best case” impact of the hedge.

On a cautionary note, bear in mind that historical performance is not a guarantee of future success and that each time it a different hedging scenario.

Finally, given high inflation with a CPI of above 7% and the CBOE S&P 500 Volatility Index (VIX) hovering between 19 and 20, the risk factors are certainly here.

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

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