Hedging with ETFs: A Simple Guide for Investors

Investing can feel like a roller coaster ride: thrilling when markets rise, but stomach-churning when they fall. What if you could smooth out some of those wild swings? There is one way.

Enter hedging with Exchange-Traded Funds (ETFs), a strategy for protecting investment portfolios against unforeseen downturns.

Let’s understand this.

What is an ETF?

An ETF, or Exchange-Traded Fund, is a type of investment fund that holds a diversified portfolio of assets such as stocks, bonds, commodities, or a combination of these, and trades on a stock exchange just like an individual stock. ETFs typically track a specific index, sector, or commodity, aiming to replicate its performance rather than actively picking stocks.

As of March 2025, there are 252 total ETFs, with the majority being equity-based. The total assets under management (AUM) stand at ₹8.38 lakh crore. Here’s a quick snapshot: 

Source: NSE Passive Investing Report

With the rising AUM, ETFs have experienced a consistent upward trend since 2017, with AUM increasing from ₹50,211 crore to the current ₹8.38 lakh crore, a substantial 1,569.15% increase.

Source: NSE Passive Investing Report

ETFs exist for a wide range of purposes: broad stock indices (such as the Sensex and Nifty), sectors, commodities (including gold and silver), bonds, international markets, and more. 

Here are a few key things that make ETFs popular among investors:

Diversification: Because an ETF holds many assets, it instantly gives you a spread of investments. For example, one equity ETF could track the Nifty 50 index, giving you a tiny ownership stake in all 50 companies. This diversification means you’re not putting all your eggs in one basket, which can consequently help cushion any negative impact.

Easy Trading: ETFs trade on the stock exchange just like a normal stock. You can buy or sell an ETF at any time during market hours, and the price fluctuates throughout the day. This is different from traditional mutual funds (which are priced once at day’s end). So, ETFs provide you with flexibility and liquidity.

Lower Costs: Typical ETF administrative costs are lower than those of an actively managed fund, coming in at less than 0.20% per annum, as opposed to the over 1% yearly cost of some actively managed mutual fund schemes, as per AMFI.

Now that we know what an ETF is, let’s clarify what we mean by hedging.

What is Hedging?

Hedging sounds like a complicated term, but at its core, it means reducing risk. If investing is about building wealth over time, hedging is about not losing too much money when things go wrong. It’s a way of “covering your bases.” 

Let’s look at it with an example:

Suppose you own shares of an airline company. You bought them because you expect air travel to boom (so airline stocks should rise). However, you worry about a surge in oil prices as expensive fuel could hurt airline profits and make your stock fall. How can you hedge this risk? One way would be to invest in an oil ETF or commodity fund. If oil prices do rise (bad for your airline stock), the oil investment will likely go up, offsetting some of your loss on the airline shares. If oil prices stay flat or drop (good for your airline stock), your airline shares can do well, and the hedge might not be needed (the oil ETF might stagnate or dip a bit). Either way, via this method, you can balance out extreme outcomes. 

Hedge Fund Style Investing Using ETFs

ETFs can be used to replicate hedge fund investment strategies by leveraging their characteristics for dynamic, multi-asset, and tactical investing, even without engaging in shorting, which is a common hedge fund practice. This approach aims to bring sophisticated strategies, typically offered by hedge funds, to a retail participation level.

Here’s how ETFs are used to achieve a hedge fund style of investing:

Three-Pillar Approach:

1. Asset Allocation: This involves deciding how to distribute investments across different asset classes.

2. ETF Selection: Choosing the right ETFs to meet the determined asset allocation.

3. Cash Calls: Making strategic decisions to hold cash instead of risk assets when needed. This also includes using cash levels of funds as a good indicator of market sentiment.

Global Macro Analysis:

This approach relies on a global macro view, which involves understanding how geopolitical, business, and policy developments impact investments in both strategic and tactical senses. 

Global macro signals, such as interest rates, policy changes, and earnings forecasts, are used to manage portfolios dynamically. 

For example, the Lotusdew ETF Tactical Asset Allocation strategy is a multi-asset portfolio that tactically allocates across equities, bonds, commodities, and cash. 

How do they weight the ETFs in the smallcase? 

Within equities, Lotusdew focuses on one to three high-conviction sectors at a time. In bonds, it shifts between long- and short-duration exposures, while commodity allocations move between base and precious metals. The strategy is driven by an AI engine that analyses public disclosures from over 8,000 global investors to identify changes in security-level conviction. These insights are aggregated from the bottom up to guide asset and sector-level positioning, offering a global macro, hedge fund-style allocation tailored for retail investors.

Here’s a more detailed video on hedging using ETFs. Check it out.

Types of ETFs Commonly Used for Hedging

Certain categories of ETFs have become popular as hedging instruments. 

1. Silver ETFs can serve as a proxy for global industrialisation, as a significant portion of global silver production is used in industries.

2. Gold ETFs are traditionally seen as a hedge against inflation.

3. Government bond ETFs or long-ended constant maturity ETFs can be used to express views on interest rates and generate capital gains if rates decline. The logic is that in a recession or market crash, central banks might cut rates to stimulate the economy, which makes existing bonds (with higher locked-in rates) more valuable

4. Equity ETFs, particularly those linked to consumption baskets or specific sectors, such as autos in India, can be chosen based on the domestic economic outlook.

5. Dividend yield ETFs can provide income in a low-interest rate environment.

5. International ETFs that let you invest in foreign stock indices (like the S&P 500, Nasdaq 100, etc.), serving as a hedge in a couple of ways. First, it’s geographic diversification. Second, they are often currency hedges. If the Rupee falls in value (especially vs the Dollar), your international ETF (which is valued in USD or other currency) is likely to go up in INR terms. 

Do note, one shouldn’t invest abroad only because of the Rupee. One should try to diversify and grow. The key is to use global ETFs thoughtfully as a hedge + diversification strategy.

Risks and Things to Watch Out For

While hedging with ETFs can be a smart move, it’s important to understand the pitfalls and limitations. Here are some things to keep in mind:

Reduced Upside: The most obvious drawback is that hedging limits your upside. If the negative event you’re worried about never happens, your hedge might act as a drag on performance. For instance, if you bought a defensive ETF and the market only went straight up, that ETF might underperform and pull down your overall gains. 

Hedges Can Be Imperfect: Just because two assets often move in opposite directions doesn’t mean they always will. Correlations can change. Perhaps you buy a gold ETF expecting it to rise if stocks fall, a reasonable assumption historically. But it’s possible during a particular crash, gold also falls or stays flat (Example: rebound in US Dollar putting pressure on the Rupee, trade tariff uncertainties, etc). 

Overhedging: Excessive protection can limit potential gains. In this case, an investor may prioritise preventing losses over capturing profits.

Market Risks: Hedging can’t fully shield you from market volatility, meaning there’s still a chance of losses despite having protection in place.

Bottom Line

Hedging with ETFs offers convenience, affordability, and effectiveness in managing risk. It’s like having a safety net that’s easy to deploy. However, it’s important to balance your portfolio, using hedging as one of the parts of your overall investing strategy. Timing and costs matter, so be cautious about when and how you hedge. Ultimately, hedging is about protecting your portfolio while staying on track toward your long-term goals.

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