Exchange-traded funds (ETFs) appeal to investors of all sizes and the selection and uses continue to change rapidly. While investors who are new to ETFs may assume that these funds are primarily used as a mutual fund substitute, the uses for ETFs have expanded far beyond the realm of just passively investing in managed funds. For experienced investors, ETFs are widely known to be used to invest in asset classes like stocks, bonds, real estate and commodities, but the use of ETFs for hedging is becoming more popular.

In fact, one of the primary benefits of ETFs for hedging can be found in their name; they are traded actively on exchanges making them much more liquid and versatile than mutual funds. Here we'll look at how ETFs can be used for hedging.

How to Hedge with ETFs

ETFs can be used like derivatives such as options and futures to take long or short positions in investment portfolios. Forward contracts used in currency hedging between two counterparties were historically reserved for large investors. Now, these types of trades can be scaled down and tailored with ETFs that invest in the underlying currency positions. Investors who are interested in hedging their portfolios against inflation can now link their future returns to commodity prices using targeted ETFs. For small investors or those with limited experience in trading commodity futures, combinations of ETFs can be used to replicate portfolios of precious metals, oil and natural gas - or just about any commodity that is covered by an ETF. The benefits of all of these combinations is the comparatively low transaction and holding costs compared to the costs of futures, options, forwards and other traditional hedging tools. The ability to purchase and sell hedging components in small increments appeals to smaller investors who previously had limited access to hedging due to the larger minimum requirements required with traditional hedging strategies.

Hedging has historically been limited to the use of derivative-based securities like futures, options, forward contracts, swaptions and various combinations of over-the-counter and exchange-traded securities. Because the mechanics of the pricing of the derivative-based securities is based on advanced mathematical formulas like Black and Scholes options pricing models, they have generally been used by large, sophisticated investors. Now investors of all sizes can access hedging tools with ETFs, which are as simple to trade as stocks.

Stock Market Hedging

Investors typically use futures and options on the stock and bond market to hedge their positions or take short-term placements to enter or exit the market. One of the most common and actively traded tools for the equity market are S&P 500 futures, which are used widely by large institutions including pension funds, mutual funds and active traders. Now, ETFs like ProShares Short S&P 500and ProShares UltraPro Short S&P 500 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. While the mechanics of using short equity ETFs is a little different than using futures, and matching the hedged positions may not be as precise, this strategy provides easy access as a means to the end. The position can also be unwound when needed - unlike futures contracts, which expire on a regular basis requiring investors to cash out, take delivery or re-hedge when the contract matures.

Hedging with Currencies

Just like with equity market hedging, prior to the wide acceptance of ETFs the only way to hedge a non-U.S. investment was to use currency forward contracts, options and futures. Forward contracts are rarely available to individual investors as they are often agreements between large entities that are traded over the counter. Also, they are typically held to maturity. Like interest rate swaps, they allow one party to assume the risk of a long position and the other party to assume a short position in a currency to liken their particular needs to hedging or betting. By design, the participants rarely take physical delivery of the currency position and choose to cash out the ending value based on the closing currency exchange rate. During the life of the forward contract, no money is exchanged and the valuation is typically based on the appreciation/depreciation of the swap or held at cost.

Now that ETFs have entered currency hedging, investors can easily hedge long non-U.S. investments by purchasing corresponding amounts of funds take a short U.S. dollar position, such as the PowerShares DB U.S. Dollar Index Bearish. On the flip side, an investor who is based outside of the U.S. can invest in shares of funds like PowerShares DB U.S. Dollar Index Bullish to take a long U.S. dollar position to hedge against their portfolios. Just like substituting futures and options in the equity and bond market, the levels of accuracy when matching the portfolio's value to the hedged position is up to the investor. But thanks to the liquidity of ETFs and their lack of maturity dates, investors can easily make minor adjustments.

Inflation Hedging

So far we have covered hedging portfolios in a traditional sense, offsetting variable risks or maintaining market positions. Inflation hedging with ETFs encompasses similar concepts but hedges against an unknown and unpredictable force. While inflation has ranged in small bands historically, it can easily swing up or down during normal or abnormal economic cycles. While commodities can be considered an asset class all on their own, many investors seek out commodities as a form of hedging against inflation based on the theory that if inflation rises or is expected to rise, so will the price of commodities. In theory, while inflation is rising, other asset classes like stocks may not be rising and investors can participate in the growth of the commodities investments. Commodity investing with ETFs has become very popular and there are hundreds of tools to access precious metals, natural resources and just about any commodity that can be traded on a traditional exchange.

The Benefits of ETFs for Hedging

The benefits of using an ETF for hedging are numerous. First and foremost is cost effectiveness, as ETFs allow small investors to take positions with little or no entrance fees. They typically have very low holding/management fees compared to the total costs of physical deliver or commissions on futures and options. They also provide access to markets (like the currencies market) that would not be cost effective for individual investors; liquidity beyond the levels found in futures and options; lower bid/ask spreads; and the ability to trade openly in stock exchanges. ETF hedging creates additional liquidity in markets, allowing for better "look through" transparency and eliminates the counterparty risk associated with over-the-counter contracts between two parties.

The Bottom Line

While hedging with ETFs is a relatively new concept and still needs to stand the test of time, it's no secret that their presence is known and investors of all sizes are taking notice.