{"id":15910,"date":"2017-12-14T08:00:00","date_gmt":"2017-12-14T08:00:00","guid":{"rendered":"http:\/\/starthostunlimiteddmffassi-ss.stackstaging.com\/etfworld.co.uk\/index.php\/2017\/12\/14\/wisdomtree-how-to-hedge-safe-haven-duration-risk-with-ultra-long-short-strategies\/"},"modified":"2017-12-14T08:00:00","modified_gmt":"2017-12-14T08:00:00","slug":"wisdomtree-how-to-hedge-safe-haven-duration-risk-with-ultra-long-short-strategies","status":"publish","type":"post","link":"https:\/\/www.etfworld.com\/co.uk\/wisdomtree-how-to-hedge-safe-haven-duration-risk-with-ultra-long-short-strategies\/","title":{"rendered":"WisdomTree : How to hedge safe haven duration risk with ultra-long short strategies"},"content":{"rendered":"

Investors holding a 3x leveraged oil ETP would have gained over 15% in the first week of November\u2014more than 3x the return of front-month oil futures over the same period. Underpinning this is an easing supply glut and a potential OPEC supply cut extension\u2014both of which, we believe, reaffirm the structural bull case for oil……<\/p>\n

<\/p>\n

By Viktor Nossek , Director of Research<\/strong><\/p>\n

\n

In articulating its exit-plan from the QE programme in October, the ECB delivered a clear message: the eurozone economic recovery is self-sustaining and no longer in need of exceptionally loose stimulus. Deflationary risks are increasingly remote.<\/p>\n

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As a result, a precedent may have been set for the eurozone\u2019s safe haven assets to come under pressure in the near future, in the same way that US Treasuries were affected during the Fed\u2019s taper talk in 2013. Most at risk are German Bunds, as aside from having benefited disproportionately from the vast quantities of fixed-income securities purchased by the ECB, their yields remain well below inflation. For instance, it was as recently as October 2016, that the yield on 10Y Bunds broke out of negative territory. Investors mandated with targeting income in Europe\u2019s high-grade bond market have been forced to take significant duration risk to do so. <\/p>\n

Those investors that have allocated to long-dated high-grade debt in Europe in the search for yield look particularly vulnerable against a backdrop of inflationary pressures building from structurally-led demand forces underpinning the eurozone recovery. These emerging pressures on consumer prices look stickier and longer lasting than the short-lived supply shocks resulting from volatile euro and commodity price pass-through effects. <\/p>\n

If now is the time to consider hedging the downside risks to eurozone long-dated fixed-income portfolios, then leveraged short ETPs tracking ultra-long German Bunds can serve as capital efficient hedging tools for investors seeking to protect their high grade, high-duration portfolios from these risks. <\/p>\n

Leveraged short ETPs are simple yet effective hedging instruments and in this article we explore their usefulness in greater detail using the concept of beta. Leveraged short ETPs are instruments that magnify the performance of their underlying exposure by a leverage factor, whilst limiting downside risk to the initial investment. <\/p>\n

Beta hedging factors to consider<\/strong><\/p>\n

The capital required to set up a hedge can be approximated by beta, or the sensitivity of the leveraged short ETP to the long investment. With beta hedging, the following factors should be considered:<\/p>\n

1) Leverage factor<\/strong><\/p>\n

The higher the short ETP\u2019s leverage factor, the higher its beta to the underlying index, and to the fixed-income portfolio benchmarked to it. For instance, if the underlying index (e.g. 10Y German Bunds) falls 0.5% in one day, a 3x short ETP and a 5x short ETP tracking the underlying index will rise 1.5% and 2.5% respectively. Higher leverage factors can increase the hedge instrument\u2019s capital efficiency, since less initial capital is required to set up the hedge. Put simply, if an investment worth $100 is hedged using a 3x short ETP, the initial capital required to do so is 1\/3rd of the investment, or $33.3. If using a 5x short ETP, the required initial amount would fall to 1\/5th of the investment, or $20. This example ignores compounding and rebalancing. <\/p>\n

2) Holding period<\/strong><\/p>\n

The effect of daily compounding on the cumulative returns of leveraged short ETPs can, in the case of directional, trending markets, magnify their performance over time. Similarly, in directionless and volatile markets, performance can be eroded. The former implies that the beta of the leveraged short ETP to the fixed-income investment can be greater than the leverage factor, the latter implies that the beta can be less than the leverage factor. As a result, when leveraged short ETPs are used as hedge overlays on fixed-income investments, the hedged position can veer off the initial set up, or targeted hedged position, if held over a period of weeks or months. Hence, investors must monitor and rebalance their hedged position to prevent their investments from progressively becoming over-or under-hedged. Rebalancing the hedged position will not only control the hedge ratio, but will also work to maintain beta.<\/p>\n

3) Duration risk<\/strong><\/p>\n

Duration approximates a fixed-income portfolio\u2019s sensitivity to interest rate changes. Efficiently hedging interest rate risk with leveraged short ETPs requires the underlying index\u2019s duration to match the portfolio\u2019s duration. Because of the short ETP\u2019s inverse exposure to the underlying fixed-income index, the short ETP\u2019s duration will be negative and will therefore offset the interest rate risk of the portfolio, acting as a hedge.<\/p>\n

Leveraged short ETPs tracking fixed income are highly sensitive to small changes in interest rates. Using the concept of duration in estimating sensitivity, if interest rates rise by 20 bps, the value of a hypothetical portfolio benchmarked to a +10Y German Bund index with a duration of 15 may fall by approximately 3% (0.20% x 15)1<\/sup><\/span>, as shown by the red line in Chart 1. <\/p>\n

For a leveraged short ETP, the sensitivity to interest rate changes increases by a multiple approximately equal to its leverage factor. Shown by the blue lines, for a 20 bps rise in interest rates, a 3x short ETP with 10Y German Bunds as the underlying exposure and a duration of 9.5 could rise approximately 5.7% (0.20% x 9.5 x -3). A 3x short ETP with 30Y Bunds as the underlying exposure and a duration of 25 could rise approximately 15% (0.20% x 25 x -3). <\/p>\n

Chart 1. How leverage and duration \u2018gear-up\u2019 performance for short ETPs tracking fixed income. Example shows the sensitivity of short ETPs\u2019 vs a fixed-income investment to different interest rate scenarios<\/strong><\/p>\n

 \"\"<\/strong><\/p>\n

Source: WisdomTree. Expected performance is only indicative and may not reflect actual returns.<\/span><\/p>\n

Optimising capital efficiency with duration and leverage: case study<\/strong><\/p>\n

To showcase how leveraged short ETPs tracking ultra-long fixed-income benchmarks can extract greater capital efficiency through the process of beta hedging, we present the following example:<\/p>\n

    \n
  • The fixed-income investment to be hedged:\n
      \n
    • A portfolio of long-dated European high-grade government bonds;<\/li>\n
    • Benchmark used: Bloomberg Barclays Germany Government Over 10Y Index; duration = 15 <\/li>\n<\/ul>\n<\/li>\n<\/ul>\n
        \n
      • The 3x short ETPs used as hedge instruments for the fixed-income investment:\n
          \n
        1. The 30-Year Bund (Boost Bund 30Y 3x Daily Short ETP; ticker = 3UBS); Duration of underlying exposure = 25<\/li>\n
        2. The 10-Year Bund (Boost Bund 10Y 3x Daily Short ETP; ticker = 3BUS); Duration of underlying exposure = 9.5 <\/li>\n<\/ol>\n<\/li>\n<\/ul>\n
            \n
          • The holding period of the hedge is four weeks<\/li>\n<\/ul>\n

            Based on daily observations of the four-week period returns between 1 January 2006 and 19 September 2017, we noticed the following (see Chart 2):<\/p>\n

              \n
            • \n
              3UBS had a beta of -3.5 vs the +10Y German Bunds portfolio benchmark, suggesting that, when using 3UBS as a hedging instrument for a period of approximately one month, the initial capital outlay for the hedge was 29% of the portfolio. In other words, this instrument effectively required less initial capital to hedge the investment than the amount implied by the leverage factor of 3x (1\/3rd of the portfolio). <\/div>\n<\/li>\n<\/ul>\n
                \n
              • \n
                Large price changes in the portfolio\u2019s benchmark resulted in a noticeable convexity in the performance pattern of leveraged short ETPs tracking 30Y Bunds. This suggests that in extreme market conditions, investors are likely to be rewarded with a performance boost to the net exposure if bond prices fall (i.e. when the % gain in notional value of the short position exceeds the % loss in market value of the long position). Furthermore, there will be less of a performance drag to the net position if bond prices rise (i.e. when the % loss in notional value of the short position falls short of the % gain in market value of the long position). <\/div>\n<\/li>\n<\/ul>\n
                  \n
                • \n
                  The beta was robust, with the variance of the four-week benchmark returns2<\/span><\/sup> explaining approximately 97% of the variance of the four-week returns of the 3x short ETP tracking 30Y German Bunds. This demonstrates how an offsetting position created with the leveraged short ETP and held for a long period will cancel out most of the interest rate risk assumed. <\/div>\n<\/li>\n<\/ul>\n
                    \n
                  • \n
                    3BUS had a beta of -1.5 vs the +10Y German Bunds portfolio benchmark, indicating that the use of the ETP as a hedging instrument required not only more initial capital than implied by the leverage factor of 3x, but also significantly more than required by 3UBS. The lower \u2018goodness of fit\u2019 compared to 3UBS, also suggests that the hedge was less effective, although the fit was still relatively high. <\/div>\n<\/li>\n<\/ul>\n

                    Chart 2: Ultra-long short exposures as a beta hedging tool. Hedging long-dated bonds through inverse exposure to proxy benchmarks of different durations – sensitivity of four-week returns <\/strong><\/p>\n

                     \"\"<\/strong><\/p>\n

                    Source: WisdomTree, Bloomberg. Data from 1 January 2006 to19 September 2017. Based on backtested data. Past performance is not indicative of future returns<\/span><\/p>\n

                    Limitations of beta hedging<\/strong><\/p>\n

                    The difference in beta and the hedge\u2019s capital efficiency is explained by the 30Y Bunds\u2019 duration of 25 vs the 10Y Bunds\u2019 duration of 9.5. With a duration of 15 for the +10Y Government bond portfolio benchmark, investors receive an additional 0.5 of beta on top of the leverage factor of 3x from the higher duration risk assumed by 3UBS\u2019s 30Y Bund as the underlying exposure. In contrast, with 3BUS tracking 10Y Bunds, the duration is substantially lower than the portfolio\u2019s benchmark, thus effectively eroding beta to less than what is implied by the leverage factor of 3x.<\/p>\n

                    Macro fundamental factors impact bonds of varying maturities differently. Consider how, looking ahead to 2018, the ECB\u2019s QE tapering, or speculation around the Fed\u2019s policy tightening in the absence of high inflation may cause non-parallel yield curve shifts in the US and the eurozone. It will limit the extent to which investors can reliably \u2018lever-up\u2019 with duration to boost capital efficiency. These factors need to be considered when hedging interest rate risk and using leveraged short ETPs as hedging instruments.<\/p>\n

                    As shown in Chart 2, the higher goodness of linear fit for 3UBS suggests that for portfolios benchmarked to +10Y Bunds, the 30Y Bund is more reliable than the 10Y Bund as an inverse proxy to the benchmark. That\u2019s not to say that for shorter-dated bond investments (e.g. maturities of 7-10 years), 3BUS may, despite a lower beta than 3UBS, end up being a more robust hedging instrument. <\/p>\n

                    Rebalancing the portfolio when the hedge ratio drifts too far off target may improve the hedged portfolio\u2019s performance, especially in abnormal or extreme bond market conditions. Investors should be cautious of extreme bond valuations in such conditions. Last year\u2019s negative to near-zero yield period for Bunds triggered a sharp sell-off, with low coupon yields and elevated prices adding to the Bund\u2019s convexity. This underscores the upside performance potential of leveraged short ETPs and their effectiveness as tactical hedging tools.<\/p>\n<\/p><\/div>\n<\/p><\/div>\n

                    Source: ETFWorld.co.uk<\/p>\n","protected":false},"excerpt":{"rendered":"

                    Investors holding a 3x leveraged oil ETP would have gained over 15% in the first week of November\u2014more than 3x the return of front-month oil futures over the same period. Underpinning this is an easing supply glut and a potential OPEC supply cut extension\u2014both of which, we believe, reaffirm the structural bull case for oil……<\/p>\n","protected":false},"author":3,"featured_media":18145,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"telegram_tosend":false,"telegram_tosend_message":"","telegram_tosend_target":0,"footnotes":"","_wpscp_schedule_draft_date":"","_wpscp_schedule_republish_date":"","_wpscppro_advance_schedule":false,"_wpscppro_advance_schedule_date":"","_wpscppro_dont_share_socialmedia":false,"_wpscppro_custom_social_share_image":0,"_facebook_share_type":"","_twitter_share_type":"","_linkedin_share_type":"","_pinterest_share_type":"","_linkedin_share_type_page":"","_instagram_share_type":"","_medium_share_type":"","_threads_share_type":"","_google_business_share_type":"","_selected_social_profile":[],"_wpsp_enable_custom_social_template":false,"_wpsp_social_scheduling":{"enabled":false,"datetime":null,"platforms":[],"status":"template_only","dateOption":"today","timeOption":"now","customDays":"","customHours":"","customDate":"","customTime":"","schedulingType":"absolute"},"_wpsp_active_default_template":true},"categories":[12],"tags":[148],"class_list":["post-15910","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-etf-analysis","tag-wisdom-tree-europe-boost-etp"],"blocksy_meta":{"styles_descriptor":{"styles":{"desktop":"","tablet":"","mobile":""},"google_fonts":[],"version":6}},"_links":{"self":[{"href":"https:\/\/www.etfworld.com\/co.uk\/wp-json\/wp\/v2\/posts\/15910","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.etfworld.com\/co.uk\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.etfworld.com\/co.uk\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.etfworld.com\/co.uk\/wp-json\/wp\/v2\/users\/3"}],"replies":[{"embeddable":true,"href":"https:\/\/www.etfworld.com\/co.uk\/wp-json\/wp\/v2\/comments?post=15910"}],"version-history":[{"count":0,"href":"https:\/\/www.etfworld.com\/co.uk\/wp-json\/wp\/v2\/posts\/15910\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.etfworld.com\/co.uk\/wp-json\/wp\/v2\/media\/18145"}],"wp:attachment":[{"href":"https:\/\/www.etfworld.com\/co.uk\/wp-json\/wp\/v2\/media?parent=15910"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.etfworld.com\/co.uk\/wp-json\/wp\/v2\/categories?post=15910"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.etfworld.com\/co.uk\/wp-json\/wp\/v2\/tags?post=15910"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}