Modern Portfolio Theory has served for decades as the foundation of investment management, the long-term asset allocation strategy designed to extract optimal returns with minimal risk. Money managers have widely embraced the proven method of selecting diversified portfolios: Set objectives based on financial goals, determine risk appetite, buy and hold for the long term and rebalance a couple times a year.

But that strategy did not survive the global financial crisis of 2008, as all asset classes went down and all correlations went up. The crisis and a number of other violent market dips over the last 20 years have prompted a pivot to a more modern tactical management approach. Managers have multiple options when they anticipate a downturn. They can take the hit and ride out the volatility, or sell, which means risking a loss on any gains and creating taxable events. The other option: they can hedge their position.

It is this last option that is fundamental to the more modern, tactical approach. And the investing world is often unaware of the hedging role one particular vehicle— the single inverse exchange-traded fund—plays during a decline.

Many institutions and professional investors are turning towards hedging strategies to reduce the risks of market volatility, while staying invested in the markets. The single inverse ETF seeks 100% of the inverse performance of an index, going up when the market goes down and down when the market goes up. It allows investors to short specific sectors and asset classes, hedging the overall portfolio or a single stock exposure, with daily compounding that’s less than that in a -2x or -3x leveraged ETF. We can fully appreciate the power of this tactic by looking at two simulated hedged scenarios based on recent market turmoil.

 While most investors hedge between 10% and 20% of their portfolio, the scenarios are based on 50% hedges to magnify the benefit. In the first scenario (see below), we look at activity after the China stock market went into a freefall last year. Outright shorting of the underlying ETF that tracked China A-shares, those that trade on the two Chinese stock exchanges, would have only been possible if there were stocks to borrow. Without stocks to borrow, many discovered they could invest in a China inverse product for the same purpose.

Simulation shows hedged investment in the Direxion Daily CSI 300 China A Share Bear 1x Shares (CHAD).

The inverse fund became an access vehicle for U.S. investors to gain exposure that wasn’t otherwise available when demand was high because of a market crash. China experienced declines from the end of December 2015 through January 2016. The unhedged portfolio took those hits, but the portfolio with a 50% hedge in a China inverse fund was left largely intact. Advisors were able to use a single inverse fund to either hedge their position or take an inverse view.

They avoided a long China exposure that would have resulted in a $20 per share loss during the volatile period, most notably January. Hedging out with an inverse fund essentially kept the notional value of the China exposure neutral.

We see a similar pattern when looking at activity in biotech from December 2015 to May 2016 (see below), plotting the unhedged portfolio alongside one with a 50% hedge, invested in an ETF that is 100% of the inverse of the performance of the S&P Biotechnology Select Industry Index. 

Simulation shows hedged investment in the Direxion Daily S&P Biotech Bear 1x Shares (LABS).

The sector experienced several declines during this time in the index, particularly from December to the end of January when there was a huge dip, leaving the unhedged investor to lose about $35 per share on the biotech portfolio. With an inverse fund, the investor here also would have maintained the initial notional value within the portfolio and remained market neutral.

When the market falls, investors may be seeking to trade into defensive sectors, trade options or futures, or perhaps sell equities and move to cash. But changing portfolio allocations can be expensive and investors may not want to sell stocks of a company that, for example, is positioned to pay dividends for years to come. The single inverse fund allows that investor to stay active by participating with a hedge without having to short securities, enter into an options or futures contract, or render market timing virtually impossible in the case of moving to cash.

There’s no way of knowing when we might experience a pullback in this long-running bull market. But, with these inverse funds, investors can not only express a bearish opinion with a particular index, they can add a layer of protection to their portfolio without having to sell positions. The hedging investor views the single inverse ETF as a way to keep trading while neutralizing volatility without dismantling the portfolio.

Even a small allocation of capital could more than make up for any losses sustained in a market decline. It is an inverse correlation with flexibility, accessibility, intraday pricing and liquidity that goes beyond just expressing that bearish view. Inverse ETFs are a cost-effective, simple tool for hedging a portfolio, an alternative to the high costs and risks of using options and futures, and a new way to confront risk in a world where market declines have become the norm.