Enhancing The Efficiency Of Hedging An Investment Portfolio With Sector-Based ETFs

As investors look for ways to protect their investment portfolios from market shocks, finding the most efficient hedging instrument becomes a top priority. Clearly, hedging the risks of a 100 stocks portfolio with sector-based ETFs is more efficient than hedging it with single stock options or S&P 500 Index option/ETF.

Below we will present our analysis in support of the above statement.

We will start with reminding that ETFs are a composite of securities traded on the stock exchange and tracking underlying indexes posted on exchanges such as the Nasdaq, the New York Stock Exchange (NYSE), and others.

First, securing a portfolio through hedging each and every security in a portfolio is expensive. Let us assume, we have a portfolio of one hundred securities. First, such hedging is usually done by purchasing the put options. Thus, along with paying a commission for each transaction with these 100 securities, an investor pays the price of options relative to the price of the hedged securities, which, as a rule, is greater than the cost/price proportion for an ETF.

This is exactly the reason why hedging a portfolio of securities with options, or even hedging each individual portfolio security is not a feasible exercise. Therefore, we must examine why hedging portfolios with sectors-based ETFs is more effective than hedging with a general index such as SPY option.