This year is fast becoming known as the year the markets stopped being aligned with the economy.
The ASX, along with international markets, has seen some amazing gains from its March lows to now, while the world suffers in the wake of the COVID-19 pandemic. The lack of market correlation to the state of the economy is a confusing notion. As an investor, it can be challenging to see the forest from the trees amid this unpredictability.
Even if you do expect further correction to occur in our market, selling your shares may not be your preference as this can result in paper losses (and gains) being realised. There is another way to protect yourself by using ASX ETFs as a hedge.
What is a hedge?
While no one has a crystal ball, it can be comforting to know that you have options available to you if you want to hedge your ASX portfolio against the risk of further downturns. The concept of hedging is nothing new, but for those investors a little fresh to the game, here is one definition:
"A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security." – Investopedia.com
Essentially, if you are holding ASX 200 listed companies and are planning to retain your holding through a downturn period, you could also invest in an ASX ETF that is negatively correlated to the S&P/ASX 200 Index (ASX: XJO). This means that if your holdings were to drop in value, your ETF position is likely to rise. To me it is simple – hedging your portfolio means you can sleep a little better at night.
3 ETFs to consider for a potential downturn
The following ETFs have been included as they directly relate to the Australian and American markets. As in investor, if you purely hold shares on the ASX, the first two are likely to be more relevant to you.
It should be noted that a significant number of 'negative correlation' ASX ETFs are available to retail investors. If you are considering this strategy, it is worth conducting further research to understand all available options.
Australian Equities Bear Hedge Fund (ASX: BEAR)
BEAR aims to produce returns that are negatively correlated to the returns of the ASX 200. If the ASX 200 moves -1%, BEAR can be expected to be positive +1%.
Australian Equities Strong Bear Hedge Fund (ASX: BBOZ)
BBOZ aims to produce magnified returns that are negatively correlated to the returns of the ASX 200. If the ASX 200 moves -1%, BBOZ can be expected to be positive +2.4%.
US Equities Strong Bear Hedge Fund (ASX: BBUS)
BBUS aims to produce magnified returns that negatively correlate to the returns of the S&P 500 Index, hedged to Australian dollars. If the S&P 500 moves +1%, BBUS can be expected to be negative -2.5%.
How to use these ETFs to hedge against a market correction
As an example, lets look at how we can hedge a $10,000 portfolio against another potential market correction. If you're concerned about a 10% fall in the market, you may wish to hedge 10% of your portfolio. In this case, you would purchase $1,000 worth of BEAR shares (standard negative correlation) or as little as $500 worth of BBOZ shares (magnified negative correlation)
The great thing about these ETFs is that you buy them the same way you buy shares on the ASX. This makes it extremely easy to hedge your portfolio quickly.
Now, you might be thinking that you could use these same ETFs to profit from a falling market, and you're right. While the context of this article is to discuss portfolio protection, it is possible that investing in bear market ETFs could also produce some profit when the market falls.
Foolish takeaway
Buying ETFs is no different to buying shares. Markets can certainly be confusing and 2020 takes the cake! Adding ETFs to your portfolio can offset some risk, provide profit in a falling market and maybe even help you sleep a little better at night.
