In India Exchange-Traded Funds were launched years ago but it did not gain much of prominence primarily due to the out-performance of active fund managers and few other factors. However, investors have shown a keen interest in these products ever since Gold ETFs came into existence. Riding on the success of these, even the government have realized its effectiveness when it executed disinvestment process completely through ETFs. Now, very recently, to take exposure in equity markets EPFO invested almost Rs 4000 cr in 2 ETFs of SBI mutual Fund. Another Rs 4000 Cr is on the block to come through this mode. With long-term retirement money flowing in ETFs it will not be incorrect to say then that we will see the emergence of this vehicle on a much bigger scale.
Hedging With ETFs
ETFs has its own inherent advantage which makes it a considerable investment option. The first and foremost is the ease of investing since it can be traded like a stock and in real time. Then there is lower cost and high liquidity which attract investors most. The last and probably the most lucrative advantage is that ETFs can be used widely for hedging investments. In developed countries like US and UK the presence of ETFs almost in all sectors makes it a viable instrument for hedging.
To understand hedging – it’s a strategy of minimizing your losses by taking an opposite position while you are investing in equity markets. In general, when you buy a particular stock you also take a reverse position using options so that if markets run otherwise you are minimized with your losses. Till now derivatives such as put and call options have been very effective in hedging investment portfolios. Mutual Funds in their underline investments use these derivatives for executing hedging strategies within the applicable rules. But ETFs provide a very good avenue to hedge one’s investment portfolios. Globally hedging through ETFs have now moved to commodities, currencies and even inflation apart from stocks.
Here we look at some of the primary hedging strategies which may not be practiced in India yet but surely illustrate the advantage of using ETFs-
Hedging In Asset Classes
While you are invested in various asset classes there can be hedging strategies to minimize potential losses from one asset class with a position in a different asset class. This can be implemented due to the fact that at times bonds and stocks move together. Creating a diversified portfolio without ETFs will always be a difficult task for small investors. That’s where ETFs play a bigger role in preparing a balanced portfolio.
Take for instance Bond ETFs available in various countries. Now if you hold a single stock you can take a position in a bond ETF. When bond and stocks move in tandem they will balance out each other thus giving a cushion to investors from volatility in a single asset class. Similarly, there are Exchange Traded products in commodities wherein a single diversified commodity ETF or several commodity ETFs can be used effectively to hedge among asset classes.
Hedging In Stocks
If you have a sector ETF the hedging in stocks can be lot easier. This sector ETF will take a diversified position in various stocks and it will track the specific sector. What can make it a viable option is its high liquidity and presence of put and a call option. By taking a reverse position against the stock with the sector ETF the hedging can be used effectively. For instance, you have taken a long position in stock but do not know the direction of the market and so worried about your long positions w.r.t. selling of stocks. In such scenario, you can short sell or take a put/call option in the ETFs. If the stock declines then your short position in your sector ETF will offset the loss you make in a long position.
This hedging strategy can only be effective if the stock has some correlation with the sector and the sector ETF is covering almost every stock in the sector. Also, the markets should allow short selling ETFs and presence of options within the ETFs. This is more prevalent in develops markets like UK or US where you have these opportunities available to draw the strategy.
Inflation Hedging
Inflation hits all of us. It diminishes the purchasing power wherein value of investment one achieve may not be enough to meet the desired need. ETFs can be used as a hedging tool to compensate the rise of inflation. Commodities prices rise whenever there is a rise in inflation. In general ETFs like Gold or metal will see a sharp increase in tandem with inflation. By taking exposure in these commodities ETFs an investor can partially hedge with the rise in inflation. The other option for hedging is shorting of bond ETFs since bond prices tend to fall with the rise in inflation. Globally there are Inflation Protected Bond ETFs which invest to provide investors cushion with inflation.
Currency Hedging
When you start taking exposure in other countries then one of the major risk investors dealt with is the currency risk. Along with the stock, there will be probabilities when the currency of the country you have taken an exposure appreciates or depreciates. The profit or loss will depend on how the currency is valued at the day you redeem your money. To hedge this risk the exposure in currency ETFs can be taken when you buy the stock. Ideally, you buy the equivalent amount of foreign currency along with selling your local currency thus effectively you are selling and buying at the same time. Globally currency hedged ETFs has a wide presence giving investors enough room to hedge their foreign asset exposure.
India – What Are The Opportunities?
Coming to Indian situation, ETFs have not really gone so far as we have ETFs only with equities and gold. We have not reached a situation where shorting of ETF is allowed or we have not yet brought options within ETFs. The basket of ETFs we have are cash based much like any individual stock. It simply means that you can buy and sell those ETF in cash and can’t really hold them as equivalent to futures and options. This makes hedging of stock with ETFs almost unviable. However, we do not have Index ETFs which can provide hedging strategies. NSE also has allowed cross-margin facility with three Index ETFs- Nifty BeeS, Nifty Junior Bees and IIFL Nifty. This cross-margin facility is available in following combination:
- ETF and constituent stock futures in F&O segment
- ETF and constituent stock positions in Capital market segment
- Index futures and ETF in Capital market segment
To help you understand – in a cross-margining facility existing position or holding of one category is used to offset margin requirement while dealing in another category. For instance, you hold 1000 shares of Reliance stock and wish to buy 500 stock futures of the same. In this case, you will have to pay margin for only 500 shares which in absence this facility you would have to pay margin for entire 1000 shares. Thus, with availability of cross margining total margin payment requirement gets reduced which in turn reduces your trading cost.
Coming to hedging strategies with ETF we see the opportunity available only with Index ETFs and Index Futures. For instance based on the market direction you have shorted 1 nifty future which is actually a lot size of 75. Now To cover up the position you buy similar value of Nifty BeeS units. So if markets move up by 100 points then the value of NIFty BeeS units will also move by the same value. However, you can still have a minor difference considering there is tracking error involved in ETFs.
The hedging strategy highlighted here is not much in practice. More applicability of ETFs is when you can hedge individual stocks, inflation or even currencies. Globally Inverse ETFs, Leveraged ETFs, Inflation Protected Bond ETFs and ETFs with Options are being used for hedging strategies. With growth of ETFs In India, we will see emergence of such innovative ETFs. As a financial advisor, you should be well aware of these Investing Options which will help you use these strategies in hedging your clients portfolio especially when you invest in direct equities or commodities.
This article is authored by me first for FPSB India Journal April issue.
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