2023-06-25 23:55:31 ET
Summary
- In 2023, despite expectations of a market collapse, equities rallied as short positions were covered and long put positions closed.
- Hedging strategies, such as selling equities or using inverse ETFs like ProShares Short S&P500 ETF, can help reduce risk for retail investors.
- A risk-off event is expected in the second half of the year, and investors should consider hedging strategies to protect their portfolios.
- There will be a basis between SH's performance and SPY's performance in any given year.
Thesis
In 2023, we have seen the rally that nobody wanted. With all the banking analysists screaming for a market collapse in Q1, a significant proportion of market participants set themselves short to take advantage of said expectations. Unfortunately, that is not how markets work, and if everybody is expecting a certain event, you can be pretty sure the opposite will occur:
Hedge funds betting against stocks in the technology sector rushed to unwind those trades in the first half of February as markets rallied. "The short covering in U.S. tech stocks from Jan 31st to Feb 15th is the second largest in magnitude over any 12-day period in the past decade," Goldman Sachs wrote in a note reviewed by Reuters.
As the doomsday Q1 events did not materialize, more and more participants started covering either outright shorts or closing long put positions due to theta decay . As momentum picked up, equities rallied, with metrics now firmly entrenched in the ' Extreme Greed ' section.
We are of the opinion we are going to see a risk-off event in the second half of this year, and in this article we are going to discuss a couple of strategies that can be pursued.
What is Hedging and why do it?
Hedging comes from the old English word 'hecg', meaning originally fence, and with the figurative sense of 'boundary, barrier'. In modern 'Finance speak' hedging refers to putting a barrier around market moves, or better said reducing risk. There are several ways to reduce risk when a retail investor is long equities:
1. Outright sell equities: this one is very straight forward. If you own equities and you want to reduce risk, you can just sell them. The only issue coming up here is around tax gains/losses, and ability to have a certain entry cost for a name. Many investors use a 'dollar cost average' approach when buying certain stocks or indices, and like to have that as low as possible for a 'mental gain' type of situation. Even if you lose some mark to market during a certain year, if your entry point is still lower than the current price, you have still made money on that position, which helps psychologically to mitigate losses.
2. Hedge via inverse ETFs such as the ProShares Short S&P500 ETF ( SH ). We are going to go into details regarding the SH structure in the below section, but suffice to say this is a -1x inverse ETF tracking the S&P 500. If the index collapses -10%, SH is set to gain somewhere close to +10%.
3. Hedge via puts. An investor can reduce risk by purchasing put options. The issue with this form of hedging resides with the decay of the option premium as the maturity date is approached. There have been numerous players this year who were forced to close their long put positions or saw them expire worthless (in this case the premium is lost).
ProShares Short S&P500 ETF Structure
SH (ProShares Short S&P 500 ETF) is an inverse exchange traded fund:
ProShares Short S&P500 seeks daily investment results, before fees and expenses, that correspond to the inverse (-1x) of the daily performance of the S&P 500.
The vehicle achieves the desired daily returns by mostly using swaps:
Swaps are the cheapest structural form utilized by inverse ETFs due to their low cost. We can see SH has a bit of futures exposure as well, based on the last Semi-Annual report. On the opposite side of the spectrum when it comes to costs we can find funds such as AdvisorShares Ranger Equity Bear ETF ( HDGE ), which short individual stocks outright, action which incurs significant costs:
Short selling refers to the process of selling a security not owned by the investor with the intention of buying it back at a later date at a cheaper price. Since the investor doesn’t own the security, he typically borrows it from a broker/dealer and short sells it in the market.
The cost of borrowing a stock to short can vary but typically ranges from 0.3% to 3% per year. The fees are applied daily. The borrowing fee can be much higher than 3%, and can even exceed 100% in extraordinary cases.
As an easy rule of thumb, the higher the short interest in a particular name, the higher the cost to borrow said stock. Utilizing swaps is cheaper, and SH ends up with an expense ratio of 0.89%
What is the market telling us?
The market has rallied significantly this year:
The SPY is up over 13%, while SH is down around -11%. Please keep in mind SH is designed to mirror the daily moves in SPY, thus the differential between the two instruments year to date.
Despite the market rally, leading economic indicators keep moving down:
While we acknowledge the economy is not the stock market, eventually the two do sync up. We do not think a soft landing will occur, and having equity prices close to their all-time highs while rates have spiked to 5% is a bit of an oxymoron.
The market is currently in a state of euphoria, experiencing extreme greed:
Market timing is virtually impossible, but all indicators do point to some sort of -10% or higher retracement in the second half of this year. SH will come in handy when that happens.
Conclusion
SH is an inverse exchange traded fund. The vehicle aims to offer -1x of the daily performance of the S&P 500. The fund is down -11% this year while the SPY is up 13%, highlighting that basis. SH is not a buy and hold fund, but a hedging tool. Retail investors who want to reduce risk but do not want to sell their holdings (for tax or other reasons), can do so by purchasing SH. We believe the current equity exuberance is unwarranted, with all fundamentals pointing to deteriorating economic indicators. The stock market will eventually end up catching up to the fundamentals in the second part of 2023. Having been propped up by short covering so far this year, stocks will eventually need to re-price on fundamentals. We think reducing risk via SH is a prudent approach to an equities portfolio, thus rate it as a Buy .
For further details see:
SH: Time To Start Hedging