How to use ETFs to hedge the market

Ash-Stacey1

ETFs have come a long way since the launch of the Toronto Index Participation Units product in Canada just over 25 years ago. The increasing range and sophistication of ETFs on the market has opened up a world of new opportunities for investors, including strategies that were more commonly associated with hedge funds.

Multi-asset momentum strategies, for example, have long been used by hedge funds. Now, with an ETF tracking almost every conceivable asset class in an easily traded, low-cost vehicle, it is possible for fund managers in the regulated arena to offer investors a pure momentum multi-asset strategy via a Ucits or non-Ucits retail scheme structure. This means a higher degree of liquidity and comes without the opacity, charging structures and minimum investment requirements of hedge funds.

How does such a strategy work? The momentum investor has no interest in company fundamentals or the likely impact of macroeconomic conditions. Instead he or she will focus solely on price trends, identifying positive price momentum in a particular asset class, jumping on the trend and then sticking with it, and reaping the rewards, until the trend reverses – or another asset class offers greater potential returns.

For example, an investor may identify that there is positive price momentum in UK small caps and will buy in and ride the trend in that asset class until it is exhausted. Previously, buying the entire UK small cap index would have been an impractical proposition given the illiquid nature of small companies. Now though investors can use the iShares MSCI UK Small Cap Ucits ETF to buy or sell the asset class at any point during the trading day and at relatively low cost.

With the diverse range of ETFs available, it is perfectly feasible for a manager to achieve exposure to more than 30 asset classes using ETFs. All the main equity indices are covered, of course, but it is also possible to buy the commodities index, via ETFS Short All Commodities, or the European property market, via the iShares European REIT ETF. There is also the ability to gain exposure to UK government bonds via a product such as the iShares UK Gilts 0-5 Years Ucits ETF.

ETFsgraph

Serious investors will need no reminder that asset prices can travel down as well as up. And in a pure momentum strategy, a negative price trend also offers an opportunity. If the trend is strong enough then the fund manager may decide to short the asset class. Here again ETFs provide a solution, in the form of the inverse ETF.

The db X-trackers FTSE 100 Short ETF does exactly what it says on the tin, making money when the blue-chip index falls. There are inverse ETFs and other exchange traded products covering all the main asset classes. For example, the db X-trackers II UK Gilts Short Daily Ucits ETF generates a positive return when gilt prices are falling and the ETFS Daily Short All Commodities Ucits ETC will make money when the Bloomberg Commodity Index is dropping.

There are carry costs to factor in and take account of compounding error with inverse ETFs that reset on a daily basis, but they will do the essential job asked of them: if your investment process tells you, correctly, that the price of a particular asset class is going to decline further then they will make money from that.

With China’s economy slowing and the prospect of interest rate rises in the US and UK on the horizon, there is every likelihood of more volatility ahead. This will further emphasise to investors the value of strategies such as momentum investing, which are not reliant on major equity markets steadily marching upwards to deliver a return for investors. With well over 5,500 ETFs and other exchange traded products available around the world, there is an ever-growing range of tools available to implement these strategies.

Stacey Ash is investment manager at iFunds Asset Management.