ETFs have found their way into countless portfolios, and many investors have even grown accustomed to utilizing them in more strategic ways, whether to add tactical exposure or help with hedging.
However, when it comes to protection strategies in particular, investors are prone to committing a number of avoidable mistakes all too often. Be sure to steer clear of these 3 ETF hedging mistakes:
1. Being Late
Perhaps the biggest mistake with hedging is that most rush to do it after the fact. That is, investors scramble to protect their portfolios only after their positions have started to incur steep losses. Once a market pullback has begun, you can expect to pay a higher premium for protection in the options market, which is where many will turn to.
The other problem is market timing related. If you rush to hedge after a downturn has already developed, and let’s say you avoid the options premium surcharge and bought an inverse equity ETF instead, you will still likely get suboptimal protection for your money at that point. Why? Because your entry is so important when it comes to executing a tactical move like that, and improper timing can lead to a costly hedge.
2. Not Hedging for the Right Exposure
Another common oversight when it comes to hedging with ETFs is related to investors not constructing a specific-enough plan, especially in the case of protecting against event risk. One mistake to avoid is mismatching your exposures.
For example, if you want to hedge your equity portfolio consisting primarily of small caps, be sure to select the appropriate instrument; for instance, choosing an inverse Russell 2000 ETF over an S&P 500 one.
The other lack of specificity is more quantitative in nature.
In the case of event risk, say the Greek Debt Crisis, ask yourself what you’re really trying to hedge for — that is, what level of downside do you want to protect your portfolio against and for how long? For starters, how will you estimate what percentage of your portfolio is exposed to Greek-related assets? What percentage drop in the S&P 500 will you assume when modeling what may happen to your portfolio? And the list goes on.
Sometimes when you can’t quantify the risk exposure in your portfolio related to a certain event, a good rule of thumb is to not modify your portfolio.
There is a plethora of evidence that supports long-term investing. So if you’re a long-term investor, trying to protect your portfolio from every correction or event risk is a surefire way to pay a high premium for insurance you never really plan to use. Put another way, you may actually do more harm to your portfolio if you try to actively protect it rather than leaving it be (just make sure to diversify and rebalance).
Plain and simple, you probably don’t need to hedge for event risk unless you wish to be very tactical.
A Better Way to Hedge With ETFs
If you’re set on hedging, consider the following tips:
- Look ahead to event risks in the calendar if you want to be tactical (and on time!). The free calendar at Forex Factory is a great resource for staying on top of events around the globe.
- Consider more options strategies. While premiums are high during stressful times in the market, another way to hedge existing exposure is to sell options.
- If there’s an event coming up that has you worried about one of your positions, it’s probably because that position is too risky to begin with — meaning that you bought more than intended or at a price you didn’t feel comfortable paying.
- You’re probably better off rebalancing your portfolio (when was the last time you did that?) than trying to hedge for any one event.
The Bottom Line
ETFs can come in handy for executing a plethora of risk-on and risk-off strategies. With hedging, be sure to ask yourself some basic questions before pulling the trigger. For starters, is it too late to hedge? Can you still do so in a cost-effective manner? Can you quantify the risk in your portfolio that you wish to hedge against?
For most long-term investors, the cost of hedging for event risk may be too high, not even counting market timing risk. So it might make the most sense to stick with a hands-off approach during high-volatility periods.
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