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Triumph of the Pessimists: Four Ways to Hedge Against Market Declines
Shorting markets is speculating, not investing, and not something we would normally cover on this (investment-focused) website. It would thus be fair for subscribers to ask why we are discussing short-selling at all.
The response to such a question has two dimensions: first, while we don't personally hedge in this way - being long-term investors, we prefer to ride out the volatility and buy on dips - this doesn't have to be the case for all our subscribers. Anyone wishing to go short equity markets for any variety of reasons is entitled to do so, and we are happy to provide information on how to do this.
Secondly, tax considerations can have a bearing on how an investor may wish to reduce his/her exposure to equity markets. In a pension account, an investor can just sell to reduce equity market exposure without any tax implications. But, in a personal account, when you sell you crystallise a tax liability. By 'shorting' the market, you can, in effect, reduce your exposure to markets, but without crystallising any tax liability.
Of the four shorting methods that we cover in this article, there is no ideal method and all involve a strong element of market timing and, therefore, speculation. That said, our preferred method is the use of a contract-for-difference account, as it is relatively simple to understand and implement, and the costs are not prohibitive.
(On a quick side-note, all of the links in this post will bring you to sites outside of GillenMarkets.)
Before we start...
However, before we start, we might explain two potentially new terms that we introduce here: VIX Volatility Index, and 'shorting an index'. Many subscribers may already be familiar with these terms but, for those who aren't, we are providing brief explanations of them here.
VIX Volatility Index
The VIX Volatility Index - colloquially known as the 'fear index' - is an index calculated by the Chicago Board of Options Exchange, the largest options market in the US. The Index takes the prices of a blend of one- and two-month options on the S&P 500 Index and uses those prices to estimate the level of volatility that investors are expecting over the next month in the S&P 500. In this way, the index serves as a proxy for expected (not actual) monthly volatility in equity markets. Higher levels in the index mean that volatility expectations have risen.
Shorting the Index
To say that one has 'sold' or 'gone short' an index is to say that one has sold shares in a company (or index, bond, or any other financial instrument) without having owned them first. Investors do this as a means of benefitting from expected declines in asset prices. Typically, only institutional clients are able to directly sell short the market.
The mechanism for shorting is simple: first, the short-seller must find an investor who already owns shares in the target company - for our example, we'll use Coca-Cola. The short-seller then borrows the shares from the investor, and sells them into the market. Coca-Cola shares currently sell for $43.80, so the short-seller would receive these proceeds upon sale. If the share price then declines to, say, $40 a share, the short-seller can buy the shares back in the marketplace at $40 a share, and return the shares to the original investor. In this case, the short-seller has received proceeds of $43.80 a share and spent $40 a share, netting a gain of $3.80 a share (less any expenses incurred, such as borrowing costs).
How to Short Equity Markets
Using the S&P 500 as our case study, we outline four alternative ways of reducing one's exposure to markets without selling our underlying portfolio of shares/funds:
- Using a contract-for-difference to sell short a standard S&P 500 Index ETF (exchange traded fund)
- Buying an ETF that itself sells short the S&P 500 Index;
- Buying a VIX Volatility Index ETN (exchange-traded note) as a proxy for shorting the market; or
- Buying put options on the S&P 500 Index.
Option 1: A Simple Short
The first way to sell short the S&P 500 Index is to sell short a S&P 500 ETF through a contract-for-difference (CFD) account that you have opened with your stockbroker. Several ETF providers have their own listed S&P 500 ETF, but in this case, we use the SPDR S&P 500 ETF as the underlying ETF. The SPDR S&P 500 ETF is run by State Street Global Advisors with an expense ratio of 0.09% per annum.
The chart on the right shows the performance of the SPDR S&P 500 ETF versus the performance of the S&P 500 Index. As one would expect for an ETF, the SPDR exactly replicates the index, which can be seen by the fact that only one line is visible on the chart (the ETF). The ETF, then, is an excellent proxy for the index.
A CFD account is, in effect, a derivative contract between two parties whereby one party agrees to pay the return on an asset to the other. In this case, the investor would agree to pay any upside in the S&P 500 ETF to the broker, and the broker will pay any downside to the investor. In this way, the investor gains all of the effects of being short the S&P 500 without actually owning any assets. (Note: pension accounts can't use CFDs.)
A CFD facility normally costs about 2% per annum above base rates in funding costs, as the CFD provider has to fund the position through borrowings. Nonetheless, with interest rates at such low levels the cost is cheap at present. The downside is that margin calls are a real possibility which can force an investor to lock in a loss. For example, if the S&P 500 were to keep rising then the loss on your short S&P ETF position will increase, and you will have to add new capital to support your CFD (loss) position.
Option 2: Buying a Short ETF
Another way to sell short the S&P 500 - and a method that pension investors can also utilise - is to buy an ETF that uses derivatives to, in effect, short the S&P 500 Index. The share price of a short ETF can be expected to decline by 1% when the market rises 1%. A suitable ETF to buy in this regard is the ProShares Short S&P 500 ETF with an expense ratio of 0.89%.
The chart on the right displays the performance of the S&P 500 Index versus the S&P 500 Short ETF. As we would have hoped, the price of the S&P 500 Short ETF looks to be a mirror image of the S&P 500 Index.
In cases like this - where two assets move in opposite directions by the same amount - we would expect them to have a correlation value of close to -100%. The S&P 500 Index and the S&P 500 Short ETF have a correlation value of -99.4%, confirming that it has, in practice, copied the performance of the S&P 500 Index in reverse.
The advantages of this approach to selling short the market are three-fold: firstly, it is simple to employ - one need only buy the S&P 500 Short ETF through a standard stockbroking account. Secondly, it can be bought through a pension account. Thirdly, because you are buying shares, there will be no margin calls in the case of a market turn - that is the responsibility of the ETF's manager who has to fund the short position.
However, there is also a downside: the costs are higher on this fund, as it is expensive for the ETF manager to maintain constant derivative contracts. The difference between the S&P 500 Short ETF and the S&P 500 ETF in terms of costs is about 0.8% per annum.
Option 3: Using the VIX Volatility Index
The third option, and also a simple one to manage, is to buy an ETF that has exposure to the VIX Volatility Index when volatility is low. This option is the trickiest to understand, so we'll explain the theory of this approach in a small amount of detail.
Volatility tends to rise when investors expect stock prices to decline - this is why the index is known as the 'fear index'. After all, it would be strange if investors feared a rising market! So, gaining exposure to the VIX Volatility Index when volatility is low acts as a hedge against declines in the market: when the market declines, the volatility should (usually) rise, which will increase the value of a VIX contract or any ETF that owns VIX contracts. This rise in value can, at least partially, offset the impact of the market decline on the value of your portfolio. It is important to note, however, that the VIX Volatility Index provides a measure of expected volatility - thus, it tells us what investors think will happen to the S&P 500 in one to two months' time. Because investors do not always call the turns correctly, the VIX Volatility Index is only an imperfect hedge. The most popular ETF that provides exposure to the VIX Volatility Index is the iPath S&P 500 VIX Short-Term Futures ETN. (It's not in fact an ETF but an ETN: an exchange traded note).
There is also a second problem with using this ETN: because the ETN invests in derivatives (the VIX Volatility Index is only a statistical measure, so one can't gain direct exposure to it), the iPath S&P 500 VIX Short-Term Futures ETN may not replicate the VIX Index exactly. Additionally, the costs of rolling over these derivatives eat into returns.
This is similar to the problem investors have with most (perishable) commodities. As investors can't actually store perishable commodities (e.g. coffee), they must buy futures contracts for exposure and these future contracts constantly roll from one date to another. Roll-over costs are incurred each time in order to manintain exposure.
The chart above on the right displays the returns of the S&P 500 Index versus the iPath ETN. The unusually low volatility in the S&P 500 has eaten into the returns on the ETN over the past five years.
The S&P 500 Index and the ETN may appear to move in (reverse) lock-step but, in reality, the correlation between the two is only -75%; as we argued before, the volatility ETN would only be an approximate hedge.
The above table on the right gives a quick guide to how the iPath ETN has hedged market declines. The table displays the four largest weekly losses of the S&P 500 since the iPath ETN was launched, and the recent setback in October 2014, and compares them with the price of the iPath ETN. It becomes immediately obvious that the iPath ETN's price has risen each time the market has declined - but the magnitude of the gain varies in each period. The sample here is small, so it is difficult to draw conclusions, but we feel the table is nonetheless illustrative of the argument that the iPath ETN is only an imperfect hedge against market declines, but, on the positive side, it tends to magnify the returns one would expect.
However, despite costly drawbacks and difficulty in understanding the ETN, the iPath ETN has the same advantages as option two: it can be bought through a stockbroking account, pension accounts can access this ETN, and there are no threats of margin calls. However, as with the ETF in option two, management costs are higher at 0.89% per annum.
In essence, using the iPath ETN as a hedge against market declines is suitable really only on a short-term basis, and, of course, this is more akin to speculation.
Option 4: Buying Put Options
The final method that we cover of reducing your exposure to the market without selling your existing holdings is to buy put options on the S&P 500 Index. A put option is a contract between a buyer and seller: the buyer pays a premium to the seller who, in return, guarantees to buy the asset from the buyer at a pre-agreed price. The buyer has the ability to not use ('exercise') the put option if they don't wish to. In plain English, you can sell the market at a pre-agreed price so that if the market subsequently declines the value of your option rises. The extra value can offset the decline in value of your underlying portfolio.
It might be helpful to take a solid example. Currently, it is December 2014 and we will imagine that you wish to protect your portfolio against a market decline between now and March 2015. In order to do this, you buy a put option on the S&P 500 Index with a strike price (selling price) of 2,050 (just below current levels of 2,075) and an expiry date in March 2015. The premium that you, as buyer, would have to pay for the option is in the range of $40 per contract, representing a cost of about 1.5% per contract. Two scenarios can then occur between December and March.
Scenario #1: Market declines below 2,050. If the market declines to, say, 1,800 by March 2015, then you can exercise your option and sell your holdings in the S&P 500 Index at a price of 2,050. Typically, what would happen is that the counterparty to the option contract would pay, in cash, the difference between the actual S&P 500 level and the price stipulated in the contract (2,050 - 1,800 = $250). In this case, you would make a gain of $210 ($250 less the initial cost of buying the put contract of $40). If you had held your original stock/fund holdings then this 'option' gain offsets the losses (to a large extent) on your underlying portfolio.
Scenario #2: Market remains above 2,050. In this case, you would not exercise your option and you would lose the cost of your option premium, $40. You would profit on your holdings in the S&P 500 to the extent that the market rises further, and would incur a loss of 1.5% from the cost of the option premium.
The put option method has the advantage of being relatively simple to understand, and can be used through a standard stock-broking account. There are several downsides, however: the buyer must pay a premium up front, and a tax liability may be triggered if the option is exercised.
Rory Gillen is founder of GillenMarkets.com, the online investment website, and author of 3 Steps to Investment Success published in October 2012.