As macro-economic storm clouds gathered in 2008, a minority of RIAs and risk-conscious investors erred on the side of caution by hedging part of the systematic risk in equity portfolios. As a result, they now look relatively smart, and they also have more capital to employ in the market rebounds that inevitably follow big declines.

With this lesson learned, it should be clear that hedging strategies can help to prevent terrible absolute performance and the lost investor confidence and business disruptions that are bound to follow. It also should be clear that financial innovations, especially in the ETF world, have made equity hedging strategies more accessible.

Yet, debate and doubt remain among professionals over whether and how to hedge systematic equity market risk. In this column, I'll share ideas that may be helpful in guiding your evaluations and decisions.

Some Background on Hedging and Risk Management

For some time, I have focused on issues relating to the challenge of managing risk and volatility in stock portfolios, especially during (or in anticipation of) downturns. In July 2003, I wrote a column about the opportunities RIAs have to use real-time risk monitoring tools. My November 2004 column described the opportunity to add a "short-the-market? asset class to separate account portfolios by selling short the most liquid ETFs.

• How to Do a Better Job Helping Clients Manage Risk
• An Attractive New Asset Class: "Short-the-Market"

In a January 2006 column, I suggested guidelines for evaluating long/short equity fund managers ? and indicated that the greatest focus should be on short-side and net-exposure management skills. We now know that many long/short hedge funds promised clients low volatility yet failed to deliver in the 2007-08 bear market, because they lost their short side disciplines and had too much net long exposure heading into the downturn.

In the summer of 2006, the firm ProShares introduced an innovative series of Short and Ultra Short ETFs. These ETFs can be easily added to a self-directed IRA, a 401(k) with a "brokerage account window,? and separate account strategies that don't wish to involve clients in the complexities and costs of short sales or hedging strategies implemented with futures or options. Initially, they attracted interest among day-traders and speculators who wanted to bet against the market.

The basic idea in using ProShares Short and Ultra Short ETFs for hedging is relatively simple. For example, suppose you are managing a mixed portfolio of mutual funds and individual (long) stocks. Having some exposure to an ETF such as ProShares Short S&P 500 (SH), which mirrors the inverse of daily price movements in the S&P 500 Index, can make the daily and weekly stock market roller-coaster ride less queasy. Any Alpha produced by the mutual fund managers or individual stock selections can be enhanced because the short ETF position reduces the total portfolio's systematic risk, or Beta. As Beta becomes a smaller component of total portfolio return, Alpha grows larger.

Although this simple idea has worked for many individual investors – especially in accounts like self-directed IRAs, where hedging previously had been difficult – it is not sufficient to meet the due diligence standards of many professional managers. In today's market, there is huge demand among investors and managers alike for reliable and cost-effective risk-hedging tools. Yet, serious questions remain how the ProShares ETFs work and whether they will deliver hedging benefits over time. Let's start to answer those questions.

How ProShares Short and Ultra Short ETFs Work

The answer begin with an understanding of the ProShares ETFs' objective, which is to track the inverse (Short) or double the inverse (Ultra Short) of a benchmark on a daily basis, before fees and expenses. ProShares' disclosure advises that:

"Investors should not expect [these ETFs] to achieve their objectives over periods longer than one day?There are several reasons for this, but the most significant one is index volatility and its effect on fund compounding. In general, periods of high index volatility will cause the effect of compounding to be more pronounced, while lower index volatility will produce a more muted effect.?

ProShares implements Short and Ultra Short strategies mainly with institutional swap (repurchase) agreements, which typically account for about 90-95% of portfolio net assets. (Most of the rest usually is in futures contracts.) The agreements are fully collateralized by interest-paying U.S. government agency securities, and the interest helps to defray annualized expense ratios of 0.95%.

ProShares has extensively modeled how its short ETFs should perform over one-year holding periods relative to benchmarks, given different levels of market volatility. For example, given 20% index volatility and a +20% return in the index over one year, the Ultra Short ETF should return -38.4%. Given the same volatility and a -20% return in the index, the Ultra Short should return +38.6%. At 40% index volatility, however, the ETF return falls off significantly in both cases, to -3.3% and -57.0%, respectively, according to the model.

ProShares introduced the first Ultra Short ETFs in an era of relatively low volatility. But as volatility soared during 2008, it became clear that the Ultra Shorts could not be relied on as effective hedging tools over any holding period longer than a month or two. The table below compares the performance of selected Ultra Shorts vs. benchmarks for the one-year period ending 11/30/08.

Source: ProShares, Semiannual Report to Investors, November 30, 2008.

On an absolute return basis, all except EEV performed well in a historic down market. But the more volatile small-cap ETFs (SDD and TWM) significantly lagged their benchmarks. And EEV, participating in the super-volatile emerging markets, was an outright failure for long-term hedging purposes, lagging its benchmark by a stunning 109.3%. None of the index volatility scenarios modeled by ProShares (hypothetically) were as bad as EEV's actual performance vs. the benchmark in this interval.

The more volatile markets become, the more "slippage" Ultra Short ETFs will show over time versus benchmarks. Eventually, some analysts believe that the most volatile Ultra Shorts (as well as their corresponding Ultra Longs) will go to nearly zero in value due to volatility.

There is still an investor following for the ProShares Ultra Short ETFs, as well as an even more volatile series of Triple Short ETFs recently introduced by Rydex Direxion. But participation is limited mainly to serious professional traders who want daily hedging exposure, as well as day-traders and speculators. (Note: Rydex also offers a series of double short sector ETFs.)

Based on this analysis, we can narrow the serious long-term systematic marketing risk hedging options in this space to the (single) Short ETFs, so let's now look at their performance over the same interval.

All of these Short ETFs except one, EUM, did a good job helping to hedge risk and avoid loss in a big down market. Several of them even provided a bonus of outperforming the benchmark. From such analysis, one might conclude that ProShares Short ETFs have some potential as hedging devices in all but the most volatile asset classes, such as emerging markets.

Over time, even the ProShares Short ETFs are likely to experience some "slippage" vs. benchmarks in times of high volatility. However, many most hedging alternatives also have slippage costs ? such as the contango in futures contracts or the premium decay in options. Even long-only investment strategies with fairly high portfolio turnover rates can experience slippage in volatile markets.

While slippage is a key factor to evaluate, let's also look at other benefits and drawbacks of using short ETFs as portfolio hedging tools.

Benefits

The prime market for ETF hedging strategies consists of accounts in which the risk-mitigating alternatives are costly, complex to administer, or not available. They include separate accounts below about $250,000 in which future, options and short sales usually are not viable. They also include most self-directed IRAs and 401(k)s with brokerage account windows, which are prohibited by regulation from engaging in most alternative hedging techniques.

Even in fairly small accounts, ETFs are cost-efficient to purchase, own, and sell.

Held in brokerage accounts or separate accounts, they offer investors more transparency than hedge funds or mutual funds.

Drawbacks

Several RIAs with whom I have discussed this topic have expressed reservations about the counterparty risk in ProShares Short ETFs. Unfortunately, ProShares has to date provided little transparency in regard to its swap counterparties or methods other than prospectus boilerplate, and this has made RIAs' due diligence more problematic.

(We requested a more detailed answer to this question from ProShares. Through a spokesperson, the firm declined to comment beyond its legal disclosures.)

The major counterparty risk would occur if a swap counterparty became insolvent and unable to meet obligations on a contract not fully collateralized by high-grade securities.

Taxes also can be an issue in years when the hedges (short ETFs) profit, because most of their taxable distributions are short-term gains. For example, Short Dow 30 (DOG) paid out $8.44 in short-term capital gain (and only 27 cents in long-term gain) at year-end 2008, at a time when its share price was about $80. For taxable accounts that have held shares more than a year, the gain could be converted to long-term by selling before the ex-date (12/23 in 2008) but, for investors anticipating shorter-term holds, hedging is best done in a tax-advantaged account such as an IRA.

A Model Hedging Program Using Short ETFs

Assuming an investment manager can become comfortable with the counterparty risk factor, we've shown that some short ETFs (but not Ultra Shorts) may have benefits as portfolio hedging tools in some situations. But which accounts and how? Here are a few recommendations:

• Focus on using a core group of the least volatile short ETFs such as ProShares' DOG, SH, MYY, PSQ and EFZ. All of these demonstrated hedging benefits in the acid-test environment of 2008.
• Use short ETFs to hedge the systematic risk of actively managed long equity strategies, such as a group of mutual funds or an Alpha-seeking separate account manager.
• Use short ETFs in tax-advantaged accounts such as self-directed IRAs and 401(k)s with brokerage account windows.
• Don't try to hedge 100% of systematic market risk. The cost of any "slippage" in short ETFs can be reduced by setting the net exposure target (of the total portfolio) between about 40% and 80% net long, as follows:

40% net long = 65% of the portfolio long and 35% short.

80% net long = 90% of the portfolio long and 10% short.

• Consider the idea of adding management value on the short side by adjusting the net exposure target for different environments. For example, move closer to 80% net long when the market appears to be bottoming and closer to 40% when it appears to be topping.

The hedging program described above may not be ideal. But it may be the best currently available to some investors who want to participate in attractive long equity strategies without exposure to all of the market's systematic risk. It also can help RIAs who manage long equity strategies avoid having their business models devastated in a year like 2008

Better ETF Hedging Solutions Are Coming

ProShares is an innovative firm that came along at the right time with a good idea. Many investors have used ProShares Short and Ultra Short ETFs to protect equity gains and earn profits in the historic bear market of the past 19 months.

Now, the questions turns to whether short ETFs can have long-term utility as hedging tools for professional investors and RIAs. I believe the answer will be affirmative for two reasons: 1) investment markets of the present and future will value risk management and capital preservation skills more than the ability to ride bull markets to high returns; and 2) given the unprecedented government intervention in financial markets, market volatility and risk may remain high for some time; therefore, this environment will continue to pose survival challenges to managers who "go naked" without hedging strategies.

I also don't believe we have yet seen the best short ETF hedging tools that the financial industry can produce. The volatility-induced slippage associated with daily index tracking and the opaque counterparty risks of swap contracts are problems that can be addressed by innovative creators of new short ETFs.

An attractive product for these "Madoff-anxious" times is a separate account with a competitive fee structure that offers: 1) successful long-equity funds or strategies; 2) a transparent ETF-driven hedging program such as the one I've described in this article; and 3) risk-based adjustments designed to protect capital against losses over time. Such adjustments potentially could be automated across hundreds (or thousands) of separate accounts using real-time risk management software to watch the risk levels in individual portfolios and place short ETF trades when systematic risk exposure crosses pre-determined thresholds.

If you want to offer this type of service to retail or institutional investors, now is the time to develop it. A huge audience of risk-sensitive investors is ready and waiting.