Market swings implied by the coronavirus pandemic mean that the volatility of financial assets surged. Many investors want to protect their positions from financial turmoil; hence, they use exchanged-traded funds.
What is ETF? It is an investment fund traded on stock exchanges. An ETF holds assets such as stocks, commodities, or bonds and generally operates with an arbitrage mechanism designed to keep it trading close to its net asset value, although deviations can occasionally occur. Most ETFs track an index, such as a stock index or bond index. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features
But that first reason for ETF’s attractivity, the low cost of borrowing, doesn’t hold as it does generally.
According to State Street Global Advisors the borrowing rate for SPY, the world’s largest ETF which tracks the S&P500 index, has increased from 10bp to 70bp since the beginning of the pandemic.
The majority of the investors and portfolio managers are trying to hedge their long position to limit as volatility get higher. To that purpose, they can use derivatives or turn to the ETF market to create profitable trades in this swinging market.
Because of the current situation, hedging position using derivatives became more and more expensive and that led market participants to use ETF, augmenting the related costs.
But how do we hedge a position using ETF? Hedging has historically been limited to the use of derivative-based securities like futures, options, and OTC securities. One strategy implying ETF hedging is to buy inverse S&P 500 ETFs, which move opposite to the stock market.
One of the most common and actively traded tools for the equity market, for example, are S&P 500 futures, which are used widely by large institutions, including pension funds, mutual funds, and active traders.
ETFs like ProShares Short S&P 500 (SH) and ProShares UltraPro Short S&P 500 (SPXU) move inversely to the S&P 500 Index and can be used in lieu of futures contracts to take short positions in the general stock market, making these positions simpler, cheaper, and more liquid.
Buying a short ETF provides easy access as a means to the end. Therefore, the share price of the inverse fund will increase in value if the stock market falls, and the increase in value can help offset losses suffered by stocks within the portfolio.
Some observers think that the cost of portfolio hedging will continue to increase and that there will be a scarcity of supply available for borrowing certain ETFs, like Mr Dusaniwsky for the Financial Times.