Exchange traded products (ETPs) can provide an effective and cost-effective hedge against the prospects of a more turbulent interest rate environment, according to new analysis from ETF provider Wisdom Tree.
Fixed income has remained popular with investors throughout the period of low to zero rates, with average allocations in 2016 hitting 51%, according to Nazim Hamid, ETF strategist at WisdomTree in Europe.
But with minds are now focused "overwhelmingly" on the risks relating to the end of quantitative easing and the potential for a rise in interest rates at some point in 2018.
"One of the main constraints for investors is often an inability to hedge using instruments such as futures, swaps or options," says Hamid. "These can be complex to manage with respect to margin, total risk and exposure management. In this context, ETPs may be used to provide an operationally efficient and cost-effective hedge."
Chart: Euro government bonds at close to all-time highs
To illustrate the benefits of hedging using ETPs, WisdomTree used its Boost Bund 3x Short Daily ETP, considering it against a benchmark provided by the Bloomberg Euro Aggregate Treasury Index during a period when Bund yields moved into negative territory and then normalising. Such a movement is considered to be relevant to an environment where central banks are raising base rates.
By using a three times' hedged ETP, an investor only need commit 25% of their total portfolio value to create a fully hedged position.
"When initiated, the portfolio is 100% hedged and by its very nature this hedge ratio is likely to evolve based on the performance of both the portfolio and the hedging instrument," says Hamid. "To maintain an efficient hedge that can provide an appropriate level of portfolio protection it is usual to maintain the hedge ratio within certain conservative boundaries."
Over a four-month testing period, WisdomTree found that the hedge performed efficiently, with an annualised volatility of 1.3% and overall returns of minus 0.5% compared to the minus 3.3% that would have resulted from an unhedged portfolio.
"Apart from the fact that the hedge performed efficiently, it is also important to note the overall transaction costs for putting on, rebalancing and unwinding the hedge," says Hamid.
As the underlying ETP consists of front-month Euro-Bund futures, the spreads and transaction costs reflect those of the underlying. "Based on historic data the total transaction costs for the hedge are estimated at less than five basis points," he adds.
Hamid concludes that short fixed-income ETPs may represent an "operationally and capital efficient means of protecting broad fixed income portfolios from upcoming macro and interest rate risks."
"After a prolonged multi-year bull market in fixed income and with considerable risks ahead with the unwinding of quantitative easing by the ECB and the possibility of a gradual albeit modest rise in interest rates in 2018, investors may wish to contemplate hedging their fixed income exposures."