This blog was updated in February 2019.
With the longest bull market run in history maturing, it may be time to start thinking about strategies and solutions that offer protection from volatility and falling markets.
A number of commentators and investment market analysts now believe that after significant market rises in 2017 and a mixed picture for 2018, the prevailing picture for 2019 may well be a slowdown in economic growth across major economies, with the potential for accompanying market declines.
If you have the view that markets will be a lot more volatile going forward or may even start to head lower overall for the year and would like to hedge your portfolio, you don’t necessarily have to sell your holdings to defend against a market downturn.
Indeed, selling your holdings may not be the most efficient way to seek to protect your portfolio. Firstly, there are trading costs to sell out of each of your positions which you may eventually want to buy back. Also, you may be liable for capital gains tax for holdings that are currently in the black. Finally, you will miss out on any dividends and franking credits that are associated with those holdings.
So what’s a potential solution?
BetaShares offers a series of “Bear” funds which trade on the ASX offering short exposure. There are two funds that provide short exposure to the Australian sharemarket, and another fund providing short exposure to the U.S. market.
Let’s take a look at what these Bear funds do.
Australian Equities Bear Hedge Fund (Ticker: BEAR) – provides investors with a simple way to profit from, or protect against, a decline in the Australian sharemarket. The Fund seeks to generate returns that are negatively correlated to the returns of the Australian share market (as measured by the S&P/ASX 200 index).
Australian Equities Strong Bear Hedge Fund (Ticker: BBOZ) – aims to help investors profit from, or protect against, a declining Australian share market. It seeks to generate magnified returns that are negatively correlated to the returns of the Australian sharemarket (as measured by the S&P/ASX 200 Index).
US Equities Strong Bear Hedge Fund (Ticker: BBUS) – aims to help investors profit from, or protect against, a declining U.S. share market. It seeks to generate magnified returns that are negatively correlated to the returns of the U.S. sharemarket (as measured by the S&P 500 Index), hedged to Australian dollars.
How do these funds provide a “short” exposure?
These funds sell (or short) SPI Futures in order to obtain their negatively correlated exposure. BetaShares’ website provides what is known as a ‘portfolio exposure’. The portfolio exposure represents the Fund’s approximate exposure, on a given day, to movements in the relevant Index. The level of the portfolio exposure indicates approximately how much the fund is expected to move on that trading day. Let’s take a look at a couple of examples (all before fees and expenses):
BEAR – Short Range: -90% to -110%. Assume current Portfolio Exposure: -99.0%
If the S&P/ASX 200 moved -1%, BEAR can be expected to be positive ~1% on that trading day (and vice versa).
BBOZ – Short Range: -200% to -275%. Assume current Portfolio Exposure: -240.0%
If the S&P/ASX 200 moved -1%, BBOZ can be expected to be positive ~2.4% on that trading day (and vice versa).
BBUS – Short Range: -200% to -275%. Assume current Portfolio Exposure: -250.0%
If the S&P 500 moved +1%, BBUS can be expected to be negative ~ -2.5% on that trading day (and vice versa).
Why would you use a “Bear” fund?
- To seek to protect or hedge your portfolio – by placing a hedge on your portfolio you’re essentially protecting yourself from some of the portfolio downside. You can select the percentage you would like to hedge, and by doing a simple calculation figure out the amount needed to purchase to get the percentage hedge desired.
For example, before fees and expenses, if a 15% hedge is desired on a $100K portfolio, then $15K of BEAR would need to be purchased ($100,000 X 15%). If using BBOZ/BBUS assuming a -250% portfolio exposure, then only ~$6K needs to be purchased ($100,000 X 15% / 2.5). As you will see, BBOZ/BBUS are more capital efficient because of the built-in gearing (but also more volatile).
- Seek to profit from a falling market – If you feel markets are going to go down in value, purchase BEAR/BBOZ/BBUS, which can be expected to go up in value as markets decline (and vice versa).
- Remain exposed to the US$ – If you currently have an unhedged U.S. equities exposure, because BBUS is currency hedged, you can hedge out equity exposure, but remain exposed to the currency. A strong US$ has historically been associated with declining U.S. equities.
- Use gearing to your advantage – Built-in gearing on BBOZ/BBUS makes it cost efficient to hedge and easy to use, considering there is no additional paperwork or new accounts needed (if you already have an account with your broker). Also, the gearing is managed within the fund so there are no margin calls for investors and you can never lose more than the initial investment, unlike a short stock position which technically has unlimited liability because theoretically there is no limit on how high a stock can go up in value.
Additional fund features
One of the advantages of these funds, which use futures, is that minimal margin (or cash) needs to be posted to fund these positions. Only a small percentage of capital needs to be outlaid to give the exposure needed. If, for example, only 5% of capital is required to obtain 100% of short exposure, this means that, for $1m of AUM, the fund only needs to ‘post’ $50k of capital. This means that $950K or 95% is still sitting in cash (or cash equivalents). This cash currently earns approximately the RBA rate ( ~1.50%), which accrues to the benefit of its unitholders.
Some things to keep in mind
Portfolio exposure or the gearing ratio changes on a daily basis. As markets decline, the initial capital has increased in value which means the gearing ratio declines. As markets increase in value, the initial capital decreases in value which means the gearing ratio increases or the exposure goes up. Whilst the fund will move approximately in-line with the current portfolio exposure on a day to day basis, over the longer term, it would be hard to pinpoint the exact return of the fund. (ie. S&P/ ASX 200 is down 10% in 3 months, what will be the exact movement of BEAR?)
As your portfolio exposure increases or decreases, you may want to periodically rebalance your exposure so that your hedge is rebalanced to its original exposure. If you started off with a 15% hedge, over time it may get to 20% or fall to a 10% hedge depending on whether your position is making or losing money. By periodically rebalancing, you ensure that the movement of your “Bear fund” moves in line with your expectation over the longer term.
Don’t set and forget. Keep an eye on your positions. Sell your position if you think markets will go on a run. These aren’t your traditional long positions that eventually tend to bounce back over time. If markets go on a strong bull run, it will take a much bigger fall just for the position to break back to even.
Please note: The Funds’ strategies of seeking returns that are negatively correlated to market returns is the opposite of most managed funds. Also, gearing magnifies gains and losses and may not be a suitable strategy for all investors. Investors in geared strategies should be willing to accept higher levels of investment volatility and potentially large moves (both up and down) in the value of their investment. Geared investments involve significantly higher risk than non-geared investments. Investors should seek professional financial advice before investing, and monitor their investment actively. An investment in any of the Funds should only be considered as a component of an investor’s overall portfolio. The Funds are actively managed and do not track a published benchmark.