Portfolio Hedging Series 03

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Part III: The Efficacy of Hedging with Inverse ETFs

Portfolio Hedging Series
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In Part I: The Significance of Portfolio Hedging, we talked about the inevitability of market downturns and ways to help dampen their effects. In Part II: Strategies for Hedging Your Portfolio, we discussed hedging with inverse exposure, in particular, with inverse ETFs. So, do inverse ETFs work?

Here, we provide you with two case studies that illustrate the potential effectiveness of using ProShares inverse ETFs to hedge different asset classes under different market conditions. Remember that ProShares inverse ETFs have one-day investment objectives. While they may be held for periods longer than one day, you should monitor your investments as frequently as daily and consider a rebalancing strategy.

Hedging with ProShares Inverse ETFs

ProShares inverse ETFs are frequently used to hedge equity and bond holdings. And, as investors have diversified into a broader selection of asset classes, it has become common to see investors hedging commodity and currency holdings as well. Let's examine case studies with ProShares ETFs used to hedge these types of assets. In all instances, a rebalancing strategy based on a 10% trigger was used—trigger-based rebalancing is explained in Part II: Strategies for Hedging Your Portfolio.

Equities

It is probably safe to say that most of us have large-cap investments in our portfolios. The S&P 500 is one of the largest and most widely followed indexes in the world. The ProShares Short S&P 500 ETF (ticker: SH) offers daily inverse (-1x) exposure to the S&P 500. If the S&P 500 falls 1% on a day, SH is designed to rise by 1%, and vice versa. Let's look at an example of a hedge using SH during an extreme market disruption: the first three months of 2020 as the unfolding COVID-19 crisis sent stocks into freefall.

Hedging Down Equity Markets with -1x S&P 500 ETF (SH)

January–March 2020

Return

Volatility

   

S&P 500

-19.60%

56.95%

S&P 500 with 10% Hedge in SH (-1x ETF)

-16.17%

44.86%

S&P 500 with 20% Hedge in SH (-1x ETF)

-13.30%

35.49%

Source: Bloomberg. The illustration used a 10% rebalance trigger. Illustration shows NAV returns. Market price returns, which more closely reflect the experience of an investor, may yield different results. The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor's shares, when sold or redeemed, may be worth more or less than the original cost. Shares are bought and sold at market price (not NAV) and are not individually redeemed from the fund. Market price returns are based upon the midpoint of the bid/ask spread at 4:00 p.m. ET (when NAV is normally determined for most funds) and do not represent the returns you would receive if you traded shares at other times. Brokerage commissions will reduce returns. For both standardized performance and return data current to the most recent month end, see PerformanceIndex returns are for illustrative purposes only and do not represent fund performance. Index returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest in an index.

As illustrated, the S&P 500 declined nearly 20% during the period and volatility spiked to 57%. Many of us are painfully aware that investors who were overly reliant on traditional diversification to control risk during that period lost significant amounts of money. Had investors been hedging their large-cap investments with SH, they could have seen reduced losses and improved volatility.

With just a 10% hedge position in SH, returns could have been improved by over 3% and volatility reduced by 12%. A 20% hedge, as expected, could have had nearly double the impact. Potential returns could have been improved by over 6% and volatility reduced by over 21%.

Fixed Income

Many investors hold long-term Treasuries or Treasury bonds as part of the fixed income allocation in their portfolio. To hedge a bond investment against rising interest rates, for example, an inverse ETF like the ProShares Short 20+ Year Treasury ETF (ticker: TBF) is often used. It is designed to seek daily inverse (-1x) exposure to the ICE U.S. Treasury 20+ Year Bond Index.

In this example, we compare the ICE U.S. Treasury 20+ Year Bond Index (the “20+ Year Treasury Index”), a measure of bond market performance, with 10% and 20% hedge positions in TBF. Treasury yields in the United States have largely declined over the past four decades, and more recently, the Federal Funds Rate was reduced to near zero. The 10- and 30-Year U.S. Treasury yields hit new lows in 2020 amid the fallout from COVID-19. From the end of July to the end of October, intermediate and longer-term Treasury yields moved higher, receiving a boost from stimulus packages and expectations of improved growth and inflation prospects. Rates and yields move in the opposite direction from bond prices, so when rates and yields rise, bond prices decline.

Hedging Rising Rates with -1x 20+ Year Treasury ETF (TBF)

July 31st–October 30, 2020

Return

Volatility

 

ICE U.S. Treasury 20+ Year

-7.04%

11.86%

ICE U.S. Treasury 20+ Year with 10% Hedge in TBF (-1x ETF)

-5.76%

9.64%

ICE U.S. Treasury 20+ Year with 20% Hedge in TBF (-1x ETF)

-4.70%

7.81%

Source: Bloomberg. The illustration, using a 10% trigger, would have required two rebalances. Illustration shows NAV returns. Market price returns, which more closely reflect the experience of an investor, may yield different results. The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor's shares, when sold or redeemed, may be worth more or less than the original cost. Shares are bought and sold at market price (not NAV) and are not individually redeemed from the fund. Market price returns are based upon the midpoint of the bid/ask spread at 4:00 p.m. ET (when NAV is normally determined for most funds) and do not represent the returns you would receive if you traded shares at other times. Brokerage commissions will reduce returns. For both standardized performance and return data current to the most recent month end, see Performance. Index returns are for illustrative purposes only and do not represent fund performance. Index returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest in an index.

If you look at returns for the 20+ Year Treasury Index, yields increased between July 31 and October 30, 2020, you'll see that returns fell over 7% with volatility nearing 12%. Even a 10% hedge would have reduced losses from 7.0% to approximately 5.8% and also reduced volatility. A larger 20% hedge could have cut losses to less than 5% and reduced volatility below 8%.

Something else to keep in mind when hedging bonds is duration—a measure of a bond's price sensitivity to changes in interest rates. In this case, the 20+ Year Treasury Index has a modified duration of 19, making TBF's duration -19 as well. You should also be aware of how your fixed income exposure is spread across the points on the yield curve, as well as which points you want to hedge. ProShares offers a suite of inverse Treasury funds that invest in bonds with a range of maturities up to 20+ years.

More Information

ProShares has been at the forefront of the ETF revolution since 2006. ProShares now offers one of the largest lineups of ETFs, with more than $54 billion in assets1. The company is the leader in strategies such as dividend growth, interest rate hedged bond and geared (leveraged and inverse) ETF investing. ProShares continues to innovate with products that provide strategic and tactical opportunities for investors to manage risk and enhance returns.

With over 60 inverse ETFs available across a range of sectors and asset classes, ProShares can help you execute an array of potential hedging strategies. Contact your tactical consultant for more information.

Index/Benchmark

Daily Objective

UltraPro Short

UltraShort

Short

-3x

-2x

-1x

BROAD MARKET

S&P 500

SPXU

SDS

SH

NASDAQ-100

SQQQ

QID

PSQ

Dow Jones Industrial Average

SDOW

DXD

DOG

S&P MidCap 400

SMDD

MZZ

MYY

S&P SmallCap 600

--

SDD

SBB

Russell 2000

SRTY

TWM

RWM

SECTOR

Dow Jones U.S. Basic Materials

--

SMN

--

NASDAQ Biotechnology

--

BIS

--

S&P Communication Services Select Sector

--

YCOM

--

Dow Jones U.S. Consumer Goods

--

SZK

--

Dow Jones U.S. Consumer Services

--

SCC

--

Dow Jones U.S. Financials

--

SKF

SEF

Dow Jones U.S. Health Care

--

RXD

--

Dow Jones U.S. Industrials

--

SIJ

--

Dow Jones U.S. Oil & Gas

--

DUG

--

Dow Jones U.S. Real Estate

--

SRS

REK

Solactive-ProShares Bricks and Mortar Retail Store

--

--

EMTY

Dow Jones U.S. Semiconductors

--

SSG

--

Dow Jones U.S. Technology

--

REW

--

Dow Jones U.S. Select Telecommunications

--

--

--

Dow Jones U.S. Utilities

--

SDP

--

INTERNATIONAL

MSCI EAFE

--

EFU

EFZ

MSCI Emerging Markets

--

EEV

EUM

FTSE Developed Europe All Cap

--

EPV

--

MSCI Brazil 25/50 Capped

--

BZQ

--

FTSE China 50

--

FXP

YXI

MSCI Japan

--

EWV

--

FIXED INCOME

ICE U.S. Treasury 20+ Year Bond

TTT

TBT

TBF

ICE U.S. Treasury 7-10 Year Bond

--

PST

TBX

Markit iBoxx $ Liquid High Yield

--

--

SJB

COMMODITY

Bloomberg WTI Crude Oil Subindex

--

SCO

--

Bloomberg Natural Gas Subindex

--

KOLD

--

Bloomberg Gold Subindex

--

GLL

--

Bloomberg Silver Subindex

--

ZSL

--

CURRENCY

EUR/USD 4:00 p.m. ET exchange rate

--

EUO

--

JPY/USD 4:00 p.m. ET exchange rate

--

YCS

--

1As of 30 April 2021

This information is not meant to be investment advice.

Shares of any ETF are generally bought and sold at market price (not NAV) and are not individually redeemed from the fund. Brokerage commissions will reduce returns.

Short ProShares ETFs seek returns that are a multiple of (e.g., -1x or -2x) the return of a benchmark (target) for a single day, as measured from one NAV calculation to the next. Due to the compounding of daily returns, Geared ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. These effects may be more pronounced in funds with larger or inverse multiples and in funds with volatile benchmarks. Investors should monitor their holding as frequently as daily. For more on risks, please read the prospectus.

There is no guarantee any ProShares ETF will achieve its investment objective.

Investing involves risk, including the possible loss of principal. Short ProShares ETFs are non-diversified and entail certain risks, which may include risk associated with the use of derivatives (swap agreements, futures contracts and similar instruments), imperfect benchmark correlation, leverage and market price variance, all of which can increase volatility and decrease performance. Short ProShares ETFs should lose money when their benchmarks or indexes rise. Please see their summary and full prospectuses for a more complete description of risks.

Bonds will decrease in value as interest rates rise.

Narrowly focused investments typically exhibit higher volatility.

There are additional risks related to commodity investments due to large institutional purchases or sales, and natural and technological factors such as severe weather, unusual climate change, and development and depletions of alternative resources.

Certain derivative instruments will subject the fund to counterparty risk and credit risk, which could result in significant losses for the fund.

ProShares Trust II is a commodity pool as defined in the Commodity Exchange Act and the applicable regulations of the CFTC. ProShare Capital Management LLC is the Trust Sponsor and commodity pool operator (CPO). The Sponsor is registered as a CPO with the CFTC, and is a member of the NFA. Neither this ETF nor ProShares Trust II is an investment company regulated under the Investment Company Act of 1940 and neither is afforded its protections.

Carefully consider the investment objectives, risks, charges and expenses of ProShares before investing. This and other information can be found in their summary and full prospectuses. Read them carefully before investing. Separate ProShares Trust II prospectuses are available for VIX Futures, Currency and Commodity funds.

The "S&P 500®" is a product of S&P Dow Jones Indices LLC and its affiliates. The "ICE U.S. Treasury 20+ Year Bond Index" is a trademark of Intercontinental Exchange, Inc. ("ICE"). "Bloomberg®" and "Bloomberg WTI Crude Oil SubindexSM" are trademarks or service marks of Bloomberg Finance L.P. and its affiliates (collectively, "Bloomberg"), and neither Bloomberg nor UBS Securities LLC and its affiliates (collectively, "UBS") are affiliated with ProShares. All have been licensed for use by ProShares. "S&P®" is a registered trademark of Standard & Poor's Financial Services LLC ("S&P") and "Dow Jones®" is a registered trademark of Dow Jones Trademark Holdings LLC ("Dow Jones") and have been licensed for use by S&P Dow Jones Indices LLC and its affiliates. ProShares have not been passed on by these entities or their subsidiaries or affiliates as to their legality or suitability. ProShares are not sponsored, endorsed, sold or promoted by these entities or their subsidiaries or affiliates, and they make no representation regarding the advisability of investing in these products. THESE ENTITIES AND THEIR AFFILIATES MAKE NO WARRANTIES AND BEAR NO LIABILITY WITH RESPECT TO PROSHARES.

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ProShares ETFs (ProShares Trust and ProShares Trust II) are distributed by SEI Investments Distribution Co., which is not affiliated with the funds' advisor or sponsor.

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