To Hedge or Not to Hedge

In 2018, market volatility has been 18% higher than it was in the prior two years. 2017 was a historic year as the calendar year average of the CBOE S&P 500 Volatility Index throughout 2017 was the lowest on record. Much ink has been spilled on the reasons why volatility has spiked, and on why markets were previously so calm. Regardless of the specific causes, investors are increasingly concerned about the resiliency of their portfolios in a higher volatility environment.

The first question that comes to mind is…What can be done to help?

Figure 1: Market Performance in 2018 Looked much Different than the prior Two Years

  S&P 500 Levels Total Return Standard Dev
2015 2,043.94 1.38% 15.46%
2016 2,238.83 11.96% 13.07%
2017 2,673.61 21.83% 6.67%
2018 2,506.85 -4.38% 17.03%

Source: Bloomberg Finance, L.P., as of 12/31/2018. Past performance and does not guarantee future results.

Of course, tactical investors have a variety of options to consider in order to protect their portfolios during market drawdowns. Short selling or utilizing derivatives are popular methods for protection strategies. However, investors’ options can be constrained by their ability to actually implement such solutions. One relatively straightforward solution is using inverse or leveraged inverse ETFs. As their name reveals, inverse ETFs go up when the market goes down, and they go down when the market goes up.

Direxion inverse and leveraged inverse ETFs are funds that seek to provide an inverse multiple (e.g. -1X or -2X or -3X) of the daily return of a benchmark before fees and expense. For example, a -1x ETF is designed to return the inverse (or opposite) of the performance of the fund’s underlying index on any given single day. In other words, should the index rise by 1%, the return of the fund, before fees and expenses, would be a decline of 1%. These inverse ETFs are available at different leverage points as well, such as 2X or 3X.

HOW DOES ONE DETERMINE WHEN TO HEDGE?

While there is no crystal ball to identify when markets may reverse direction, investors can look to certain indicators as a guide. One well known indicator is the Advance-Decline Line, which measures the number of companies in an index that are advancing versus declining. This ratio can offer insight into the breadth of the market to help gauge the market’s overall health. Figure 2 displays the 20-day average of the advance-decline line for the S&P 500 Index. Even as a moving average, this measure can be volatile; however, extreme periods are denoted by being negative 50 or below since October, 2010.

Figure 2: Declining Market Breadth can be identified using the Advance-Decline Line

Source: Bloomberg Finance, L.P., as of 10/20/10 – 12/31/2018.

One can take this analysis a step further by analyzing the performance of the S&P 500 Index during periods in which the advance decline line is showing a declining trend, prior to and leading up to when it reaches that -50 level. To do so, we analyzed periods in which the average of the advance-decline line showed consecutive declines when looked at through 5-day windows. In other words, was the advance-decline line average lower on a given day than it was 5 days ago? Was that measure lower again the next day? How about the next? This measure offers interesting insight into some of the drawdowns we have experienced in the S&P 500 since October, 2010.

Figure 3: S&P 500 Returns

Date # of Consecutive Days of Declining 5D Market Breadth Date S&P 500 A/D Reading below -50 (20D) S&P 500 Return | Warning to -50 Reading # of Days from Warning to -50 Reading
3/3/2011 7 3/17/2011 -52.75 -4.23% 11
5/31/2011 10 6/9/2011 -76.35 -4.13% 8
7/25/2011 9 8/1/2011 -65.85 -3.76% 6
11/8/2011 4 11/25/2011 -55.6 -9.08% 14
3/12/2012 6 4/12/2012 -50.65 1.38% 24
10/2/2012 5 11/15/2012 -59.25 -6.09% 33
6/13/2013 15 6/25/2013 -56.2 -2.92% 9
8/16/2013 9 9/3/2013 -87.1 -0.89% 13
1/27/2014 5 2/4/2014 -52.2 -1.46% 7
9/22/2014 10 10/17/2014 -105.45 -5.27% 20
1/9/2015 6 1/29/2015 -73.7 -1.10% 15
6/3/2015 7 6/16/2015 -60.8 -0.77% 10
8/17/2015 6 8/26/2015 -70.55 -7.65% 8
12/10/2015 8 1/26/2016 -114.4 -7.05% 34
10/24/2016 7 11/3/2016 -51.75 -2.85% 9
10/2/2018 5 10/29/2018 -85.2 -9.57% 20

Source: Bloomberg Finance, L.P., as of 10//10 – 11/20/18. The first date column indicates the date for which the last reading occurred during the period of consecutive declining market breadth. The second date column indicates the following notable S&P 500 Advance-Decline Line reading below -50. The return cited was the total return of the S&P 500 throughout that time period.

The below figures illustrate three of these periods in detail.

Figure 4


Source: Bloomberg. Performance data quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For the most recent month end performance and standardized performance, click here.


Source: Bloomberg. Performance data quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For the most recent month end performance and standardized performance, click here.


Source: Bloomberg. Performance data quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For the most recent month end performance and standardized performance, click here.

During the above cited periods of drawdowns in the S&P 500, the inverse and leveraged inverse ETFs provided pockets of positive performance that could have potentially helped arguably any portfolio with significant domestic equity exposure. The ride was smoother, too. During the 2018 October sell-off, just a 10% allocation to SPDN, the inverse -1X ETF, improved returns by almost 2%. Realized volatility also improved by almost four percentage points. A 30% allocation to SPDN resulted in performance improvements of over 6%, and a reduction in realized volatility of over 14%.

October 2nd – October 29th, 2018 Total Return Standard Deviation
     
S&P 500 Index -9.57% 22.11%
S&P 500 with a 10% allocation to SPDN (-1X) -7.56% 17.25%
S&P 500 with a 20% allocation to SPDN (-1X) -5.56% 12.49%
S&P 500 with a 30% allocation to SPDN (-1X) -3.56% 7.85%
     
S&P 500 with a 10% allocation to SPXS (-3X) -5.34% 11.49%
S&P 500 with a 20% allocation to SPXS (-3X) -1.12% 2.06%
S&P 500 with a 30% allocation to SPXS (-3X) 3.10% 8.66%

Source: Bloomberg Finance, L.P., as of 12/31/2018. Performance data quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For the most recent month end performance and standardized performance, click here.

Since inverse funds have daily objectives, holding periods longer than one day may result in a return that differs from what the total return of that period would be due to the potential for negative, or positive, compounding. Figure 5 illustrates the differences between using an inverse ETF as a hedge with and without frequent rebalancing.

The most notable takeaway was that rebalancing, or having some sort of rebalancing framework, was generally helpful, especially as holding periods became longer. When drawdowns were severe, but shorter lived, rebalancing had less of a positive impact to the outcome. The below covers a few time periods of notable drawdowns in the S&P 500 with and without a rebalancing framework around portfolio weight triggers.

Figure 5: Performance with and without Rebalancing

      50/50 ALLOCATION TO THE S&P 500 AND THE DIREXION DAILY -3X (SPXS) Rebalance Triggers (Portfolio Weight)
Date Range # of Days S&P 500 No Rebal 3.00% 5.00% 10.00%
6/30/2015 9/30/2015 64 -6.44% 3.71% 4.98% 5.45% 5.53%
12/10/2015 1/26/2016 30 -7.05% 6.73% 6.58% 6.23% 6.40%
10/2/2018 10/29/2018 19 -9.57% 11.54% 10.75% 10.44% 10.69%

Source: Bloomberg Finance, L.P., as of 12/31/2018. Performance data quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For the most recent month end performance and standardized performance, click here.

 


Direxion Shares Risks – An investment in the ETFs involve risk, including the possible loss of principal. The ETFs are non-diversified and include risks associated with concentration that results from the Funds’ investments in a particular industry or sector which can increase volatility. The use of derivatives such as futures contracts, forward contracts, options and swaps are subject to market risks that may cause their price to fluctuate over time. The use of leverage by an ETF increases the risk to the Fund. The Funds are not suitable for all investors and should be utilized only by sophisticated investors who understand leverage risk, consequences of seeking daily leveraged investment results, and intend to actively monitor and manage their investment. The Funds do not attempt to, and should not be expected to, provide returns which are a multiple of the return of the Index for periods other than a single day. For other risks including leverage, correlation, compounding, market volatility and specific risks regarding each sector, please read the prospectus.