Portfolio Hedging with Exchange Traded Funds

Thursday, August 18th, 2016

(Video Script)

Hi, I’m Damen Kloeckner from Clime.

Over the last couple of weeks, we’ve received a lot of questions around the use of Betashares Australian Equities Strong Bear Fund or BBOZ, which we have sporadically held in the Model Portfolio for some time.

BBOZ is an exchange traded fund or ETF which invests entirely in cash and equivalents whilst selling ASX 200 futures contracts at 200% to 275% of the value of its cash holding. In this way, we view BBOZ as an efficient risk management tool.

How BBOZ works
Figure 1. How BBOZ works
Source: StocksInValue

What this amounts to is that BBOZ provides strong negative exposure to the Australian market, and has performance negatively correlated to movements in the ASX 200. If the market falls 1%, BBOZ can be expected to rise 2-2.75%. If the market rises 1%, BBOZ can be expected to fall 2-2.75%.  In this way, BBOZ aims to provide investors with a simple way to profit from, or protect against, a decline in the Australian share market.

For individual investors such as yourselves, BBOZ has several advantages to using derivatives. ETF’s are easily traded as shares on the open market and are more tightly regulated than over the counter derivatives. They are typically very liquid due to support from market makers and have a high level of transparency. An ETF like BBOZ also has less downside risk than an outright short exposure.

We see BBOZ as having several potential uses in a balanced portfolio. Most obviously, it can be used to profit from declines in the Aussie share market. If you are of the view that the market will fall in the short term, holding BBOZ would give you a way to exercise that view. BBOZ can also be used to minimise or delay capital gains tax by reducing the need to sell core holdings to control equities exposure. But in our view, BBOZ’s real potential lies in its ability to provide simple, liquid and adjustable portfolio hedging.

Imagine you own a portfolio fully invested in Aussie equities. You receive all the upside and downside from movements in these stocks and to a large extent, movements in the market. To control this exposure and reduce equities risk, you could liquidate some of your holdings and hold cash. This is currently the most popular option for investors but in practice, selling stocks may be difficult due to a lack of liquidity, undesired tax outcomes or a whole host of other reasons. As an alternative, you could instead buy BBOZ. Because of its strong negative market exposure, much less of the portfolio would have to be liquidated and replaced with BBOZ than if cash was used. For each percent of BBOZ you hold in your portfolio, you are reducing market exposure by 2-2.75%.

BBOZ performance versus ASX 200, April 2015 – August 2016
Figure 2. BBOZ performance versus ASX 200, April 2015 – August 2016
Source: Thomson Reuters Datastream

BBOZ is not without its drawbacks however. Over longer periods, its 1.19% annual management fee will detract from performance to an extent. This does not prevent it being used in any of the manners described previously but we believe BBOZ is best used as a sporadic hedging tool to control market exposure during times of heightened volatility or stretched valuations.

If you would like to hear more about some of the ETF’s currently offered in Australia, please let us know in the comments below.

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2 Responses to “Portfolio Hedging with Exchange Traded Funds”

  1. Daniel says:

    If you would like to hear more about some of the ETF’s currently offered in Australia, please let us know in the comments below.. Yes Im interest in ETFs can you provide more info as per your note above

  2. Robert Bertolini says:

    What do you think of HVST ETF? How sustainable is the fantastic yield ?

    The downside appears to be a steadily diminishing capital value but if the yield can be sustained it may still be a worthwhile investment.

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