On the Use of Leveraged-Inverse ETFs to Hedge Risk in Publicly Traded Mortgage Portfolios

Abstract

The authors evaluate U.S. Treasury and real estate indexed leveraged-inverse exchanged traded funds (LIETFs), mortgage-based put options, and real estate futures as risk hedges in publicly traded mortgage portfolios under conditions of large and rapid interest rate increases. They find that two LIETFs, TBT and TTT, indexed to U.S. 20+ year T-bonds, were the most effective and efficient risk hedges. TTT performed the best. TYO, a LIETF indexed to 7–10 year U.S. T-notes, performed poorest overall. Liquidity issues limited the effectiveness of mortgage-based put options. Real estate futures proved less successful than the best of the LIETFs. The authors find that the advantages of LIETF include simplicity of implementation, limited loss potential, and high liquidity; additionally, tracking error was not a problem over the lengthy risk hedge implementation period for the LIETFs. The authors conclude that the potential for severe tracking error, when used beyond a single trading day, is the primary limitation of LIETFs, so caution is appropriate, and frequent monitoring and management by skilled traders and well-informed portfolio managers are essential.