The S&P/ASX 200 Index (ASX: XJO) is down around 4% or about 250 points since its high on 25 August.
Failing to break past the 6,200 point barrier multiple times has now led to a steady decline in the market. For those investors holding ASX 200 companies in their portfolio, this can be a little daunting. Choosing the right hedge is important if you are looking for portfolio protection.
What is hedging?
A hedge reduces risk of the overall portfolio. Its kind of like having an insurance policy.
I think hedging is sometimes over-complicated in the market. This can be quite confusing, particularly for newer investors. One thing to understand is that a hedge is normally an additional investment. As investors, you have the ability to purchase certain assets that can 'offset' the risk of loss.
This is possible in all markets and all asset classes, not only shares. It's a concept that you can embrace and deploy to protect a portfolio without needing to sell your shares.
Of course, as any transaction imposes a potential tax impact or future impact, you should always consult an accountant and a financial advisor. However, generally, you can purchase these 'hedge' assets very easily and apply instant levels of protection. It's an effective measure when the market looks rocky.
2 popular exchange-traded funds (ETF) used for hedging ASX 200 share portfolios are: BetaShares Australian Equities Bear Hedge Fund (ASX: BEAR) and BetaShares Australian Strong Bear Hedge Fund (ASX: BBOZ).
These ETFs are designed for slightly different purposes. So let's compare.
BetaShares Australian Equities Bear Hedge Fund
'Bear' is an appropriate name for a hedge fund used to combat a bear market.
Even when we aren't quite yet in a 'bear market', we can use Bear as a hedge against potential corrections.
About 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 +0.9 – 1.1%.
This is a really interesting concept. Negative correlation means the effect will be the opposite of the market movement. I say this to make it clear that it works both ways. For example, if you were to purchase Bear in a rising ASX market, it would effectively lose value. This fund requires active management.
These are the top 3 uses for Bear:
Hedging
Protect portfolios from market declines. No need to sell your existing holding if you don't want to
Profiting
Astute investors will have worked out that if Bear increasing in value in a falling market, it can also be used for profit purposes.
Convenience
Purchasing Bear units is simple and fast. You can purchase units the same way you purchase shares.
BetaShares Australian Strong Bear Hedge Fund
'Strong Bear' is also an appropriate name here. You have to hand it to BetaShares, their naming skills are up there.
About Strong Bear
Strong Bear aims to produce magnified returns that are negatively correlated to the returns of the ASX 200. If the ASX 200 moves -1%, it can be expected to be positive +2 – 2.75%.
Therefore, active management is even more important for Strong Bear.
Investing tactics are more or less the same as for Bear above.
Deciding on Bear vs Strong Bear
One thing you will notice above is that the multiplier factor is different between our 2 bears.
- Bear – 1% fall in market produces +0.9 – 1.1%
- Strong Bear – 1% fall in market produces +2 – 2.75%
This multiplier is the key to making a decision.
- If you have a lot of cash ready to deploy as a hedge, you might prefer Bear.
- If you have less cash at the ready, you might prefer Strong Bear.
As Strong Bear has a higher multiplier factor, you need less cash in the fund to produce a higher return on the way down.
Foolish Takeaway
Negative correlation ETFs are avoided by investors at times, as they seem risky and are poorly understood. They just require you to pay a little more attention.
The great thing is that they can be purchased instantly, the same as shares. This means that you can purchase them on the day of a market crash, if you had to. If you prefer to be a little more prepared, they can be purchased ahead of time.
The number one thing to be aware of is that the market could move either way.
