Mason Stevens
22 Jun, 2021

As Jesse mentioned in the introductory note to this risk-off series, investors are constantly faced with the possibility of the extreme, be it to the upside or downside.

During 2020 we were faced with both circumstances, with the global pandemic of Q1 2020 prompting one of the most violent equity and bond market sell-offs since the GFC, then the equally aggressive market rebound which has led us to this point.

Investors are now faced with the question, what will I do if and when the next tail-risk event comes around?

We propose an equally important question: what can I invest in when the next tail-risk event comes around?

On the back of increasingly hawkish dialogue coming out of the Federal Reserve, today we will touch on ETF products which may offer a potential hedge/strategy for increased volatility around interest rate expectations, a broad equity market sell-off or an aggressive extension of this bull market.

An Introduction to Alternative ETFs

There are multiple definitions which exist for alternative investments, and more if you include what constitutes an ‘alternative ETF’.

For purposes of this note, we will consider an alternative ETF to be;

  • either a passive or active strategy,
  • which is not a simple, unleveraged long-only strategy,
  • generally involves the use of derivatives or leverage

This offers us a wide investment universe to work with, with enough variety in product and strategy to offer a potential solution for our focus of tail-risk.

A large and bold disclaimer here:  that most of the products within this universe are complex financial instruments, which carry a heightened level of risk characteristics. Investors should consider not only the appropriateness of the product structure, but also liquidity of the investment, as some of these alternative ETFs operate with low volume and this may inhibit a material investment over a short time-frame.

The spectrum of alternative ETFs includes:

  • VIX (Chicago Volatility Index) Futures ETFs
  • Interest Rate Volatility Hedge ETFs
  • Leveraged Short Equity ETFs
  • Leveraged Short Fixed Income ETFs
  • Leveraged Long Equity ETFs
  • Leveraged Long Fixed Income ETFs

Each of these products operate on different trading strategies, with most (particularly the leveraged) recommending a holding period of one day – these are not buy-and-hold hedging strategies to build into a robust portfolio, but rather opportunistic trading instruments for if a tail-risk event does come along.

Tail-Risk Event: Interest Rate Volatility

It is old news to most market participants that the US Federal Reserve Bank is one of the key market movers and their ability to influence sentiment and market positioning.

In fact, these sensitives have increased in recent years as the central bank’s stimulus has grown relative to the market’s aggregate size.

There are two key issues which will affect both real and perceived interest rate sentiment:

  • sustained levels of Fed stimulus, and
  • levels of price inflation within the economy.

Particularly in equity markets, it is arguable that the Fed’s asset purchasing program is the bulwark with which investors measure how sustainable current valuations are – any indication of rate hikes or tapering of quantitative easing measures are intrinsically linked to the levels at which the equity market can operate.

If inflation continues to increase – and the Fed or market recognise the increases as as ‘sticky’ or sustainable, rather than made up of transitory factors – this will materially impact capital markets as investors begin to price this into bond yields and stock valuation assumptions.

What alternative ETFs exist which can potentially hedge interest rate volatility, or inflation for that matter?

Interest Rate Volatility Hedging ETFs

This type of ETF looks to use fixed income swap options (also known as “swaptions”) and holdings in highly liquid treasury securities, such as US Treasury Inflation-Protected Securities (TIPS), looking to profit from relative movements in short term or long term interest rates.

The product which we are most familiar with is the Quadratic Interest Rate Volatility and Inflation Hedge ETF (IVOL:NYSE).

Inflation Linked ETFs

Primarily focused on equity markets, these ETFs look to buy baskets of companies which in theory should benefit from rising levels of inflation within the real economy (a subject we have touched on in our inflation series), such as land holders, stock exchanges and commodity companies. Although not strictly an alternative ETF, in this particular tail-risk event this type of product could provide a hedge.

As an example, the Horizon Kinetics Inflation Beneficiaries ETF (INFL:NYSE) is an actively managed ETF which looks to purchase companies that should see increased revenue from rising real asset prices.

Tail-Risk Event: Equity Market Crash

Off the back of a rapid hike in interest rates or a permeated fear of inflation finding its way into general market sentiment, we could see a pull-back in equity markets as valuation models are scrapped and investor confidence deflates.

In general, a diversified portfolio and appropriate risk controls are the best course of action for investors to hedge against this sort of event.

But in the event of an investor’s portfolio being concentrated, long-only equities, it may be appropriate to incorporate an inverse equity ETF, a.k.a. a levered short equity ETF.

Leveraged Short Equity ETFs

These products are split into two broad categories: single inverse and multiple inverse.

The distinction is simple: a single inverse ETF (such as the BetaShares Australian Equities Bear ETF, BEAR:ASX) aims to return -1x the daily return of the index, whilst a multiple inverse ETF (such as the ProShares UltraPro Short QQQ, SQQQ:NASDAQ) aims to return -3x (or another multiple) the daily return of the index.

For example, if the NASDAQ 100 index was to fall -1% over the course of a trading day, SQQQ would be expected to return around +3% (ex-transaction costs and fees) as a result.

The more leveraged, the higher the level of risk associated with the investment.

It’s very important to recognise that these products are meant to be held in intervals of one trading day, since the pricing of the fund is reset constantly to achieve daily return profiles, not long term.

This is not the type of hedge that can sit in the ‘alternatives’ section of a portfolio over the long term, but rather bought in response to what an investor may think is a day in the middle of a bear market.

Leveraged Short Fixed Income ETFs

Similar to the above, leveraged short fixed income ETFs look to deliver the inverse daily performance of a particular bond index, most commonly one of the U.S Treasury indexes.

For example, the ProShares Short 7-10Y Treasury (TBX:NASDAQ) looks to return -1x the daily performance of the ICE U.S Treasury 7-10 Year Bond Index.

This type of product may be employed where an investor is not as concerned around their long equity exposure, but wants to hedge against the potential rise in long-term bond yields that may accompany a sustained increase in goods and services inflation.

Tail-Risk Event: Equity Market Rally

It is important to recognise the right-tail risk events, as well as the left-tail.

This concept is similar to the above but in reverse, so we won’t spend too long discussing.

In essence, if an investor is either short or neutral to the equity market, and wants to hedge a potential bull market or capture additional performance from market movements, they can potentially use a leveraged long equity ETF to gain 3x exposure without taking up excessive capital allocations within their portfolio.

These ETFs operate similarly to the short ETFs, so in the case of the ProShares UltraPro QQQ (TQQQ:NASDAQ), a 1% daily increase in the NASDAQ 100 would result in a 3% increase in the value of TQQQ (ex of fees and transaction costs).

As before, these are daily trading instruments and should be used with caution due to their leveraged nature.

Alternative Ending

Alternative ETFs are generally not for long-term holdings within a portfolio.

The ETFs purchase or sell complex financial instruments, employing leverage and derivatives, their underlying holdings. There can also be significant volume/liquidity constraints for larger investors looking to quickly enter or exit a position.

However, to disregard their potential use in risk-off or general tail-risk events is to sacrifice a potential tool for investors to use in various portfolio circumstances.

Use caution when considering any leveraged product and ensure you understand the mechanics of the investment, both generally and in the context of your portfolio – but know that whichever way capital markets swing, there are alternative investments which exist beyond a simple “long only” profile which may suddenly become useful.

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.