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Summary Scaled hedging has some advantages over usual market-timing. Leveraged ETFs are convenient hedging tools, but they suffer from a decay. This article calculates the additional cost of hedging a stock portfolio with leveraged ETFs. A timed, scalable hedging tactic has at least 3 advantages over usual market-timing consisting in going out of the market: adaptability to the risk level, lower transaction costs, and cashing all dividends. This previous article shows how to use a systemic risk indicator to scale a hedging position and protect my premium portfolio with SPXU . ETFs are not necessarily the best hedging tools, but they are available and understandable for all investors. SPXU has the advantage to allow hedging in an account where only long positions in stocks and ETFs are possible, and without margin. Like all leveraged ETFs, it has the drawback of suffering from a decay called beta-slippage. This article calculates the real additional hedging cost incurred by this decay in 2015 for SPXU, and for another leveraged inverse S&P 500 ETF: SDS . It also shows the decay of long leveraged ETFs. What is beta-slippage? If a volatile asset goes up 25% one day and down 20% the day after, a perfect double leveraged ETF goes up 50% the first day and down 40% the second day. On the close of the second day, the underlying asset is back to its initial price. At the same time, the perfect leveraged ETF has lost 10%: (1 + 0.5) x (1 – 0.4) = 0.9 This decay is called beta-slippage. It is a mathematical property of a leveraged and frequently rebalanced portfolio (leveraged ETFs may hold futures, options and/or swap contracts). In a trending market, beta-slippage can be positive. If an asset goes up 10% two days in a row, on the second day, the asset has gone up 21%. The perfect 2x leveraged ETF is up 44%: (1 + 0.2) x (1 + 0.2) = 1.44 It is 2% better than holding the underlying leveraged 2x on margin. Beta-slippage is path-dependent. If the underlying gains 50% on day 1 and loses 33.33% on day 2, it is back to its initial value, exactly like in the first example. This time, the perfect leveraged ETF loses one third of its value, which is much worse than the 10% of the first case: (1 + 1) x (1 – 0.6667) = 0.6667 Without a formal demonstration, it shows that the higher the volatility, the higher the decay. Hence the name of beta-slippage: “beta” is the best known statistical parameter of volatility. Of course, it is uncommon to have such price variations on an ETF’s underlying asset. These numbers are here to give an amplified vision of what happens with more realistic daily returns, day after day and month after month. (click to enlarge) SPXU in red, SPY in blue. Chart and data: portfolio123 Decay of S&P 500 ETFs in 2015 The next table gives the decay of leveraged ETFs on the S&P 500 index from 1/1/2015 to 10/15/2015 (9.5 months). It was a sideways and quite volatile market, with a worse than usual beta-slippage. The decay includes beta-slippage, and also tracking errors and management fees. Ticker Return Return of SPY x leveraging factor Decay (difference) Drag on portfolio SPY -0.52% SH (1xshort) -1.84% 0.52% -2.36% -1.18% SSO (2xlong) -3.92% -1.04% -2.88% -0.96% UPRO (3xlong) -8.69% -1.56% -7.13% -1.78% SDS(2xshort) -4.84% 1.04% -5.88% -1.96% SPXU(2xshort) -9.45% 1.56% -11.01% -2.75% When using SDS or SPXU for hedging, the hedging position represents 1/3 of the total portfolio (stocks + hedge) in the first case, and 1/4 in the second one. So the real drag on the portfolio was respectively 1.96% and 2.75% compared with shorting SPY. This is the additional cost of hedging the whole portfolio during the whole period (setting it in market neutral mode), which is not the best tactic proposed in my previous article (and service ). The cost of using leveraged ETFs with any of the proposed variable hedging tactics was much lower. Rebalancing the hedge weekly also lowers the decay due to beta-slippage (but not tracking errors). Finally, the cost is lower than losing all dividends when going out of the market in a classic market-timing approach, and it is likely to provide a better long-term risk-adjusted performance. SSO and UPRO also look like decent alternatives: SSO had the lowest portfolio drag. But short selling always incurs additional risks and borrowing costs. SDS and SPXU allow to hedge without borrowing cost and with less or no margin cost. These costs depend on the broker, so the best choice for hedging with an ETF may depend on your broker. If you have the skills and possibility to manage other instruments like futures, options, CFDs, they may be more cost-effective. Keep also in mind that the hedge and the stock portfolio can be in different accounts. If you like this article, you might be interested in the next ones. Click the “Follow” tab at the top if you want to stay informed of my free-access publications on Seeking Alpha. You can even choose the “real-time” option if you want to be instantly notified. Scalper1 News
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