Is Minimum Variance Hedging Necessary for Equity Indices? A study of Hedging and Cross-Hedging Exchange Traded Funds

Carol Alexander and Andreza Barbosa ()
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Andreza Barbosa: ICMA Centre, University of Reading

ICMA Centre Discussion Papers in Finance from Henley Business School, University of Reading

Abstract: This paper investigates the optimal short-term hedging of Exchange Traded Fund (ETF) portfolios with index futures. Using daily data from May 2000 to December 2004 on the four largest passive ETFs (the Spider, the Diamond, the Cubes and the Russell iShare) and their corresponding index futures we examine the performance of minimum variance hedges for efficient variance reduction and for investors with exponential utility. Our findings relate to daily hedging based on OLS regression, exponentially weighted moving averages and ECM-GARCH models and the utility-based performance evaluation criterion is adopted to capture an efficient reduction in skewness and kurtosis as well as the variance. The basis risk on US equity indices is now extremely low and as a result we find no evidence that minimum variance hedge ratios outperform a naïve 1:1 futures hedge, either for individual ETFs or for portfolios of ETFs. Where minimum variance hedge ratios are useful is for the cross-hedging of ETFs, i.e. the netting of long-short positions prior to placing a futures hedge. We also find that hedging of an ETF portfolio with just one index future can be almost as effective as hedging with all the relevant index futures. Our results should be of interest to tax arbitrage investors in ETFs and their market makers, who often face large and heterogeneous creation and redemption demands on different ETFs. Both types of traders may consider hedging their positions overnight or over a few days.

Keywords: Exchange Traded Fund; Hedging; Minimum Variance; Utility (search for similar items in EconPapers)
JEL-codes: C32 G10 G15 (search for similar items in EconPapers)
Pages: 31 pages
Date: 2005-12
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Citations: View citations in EconPapers (1)

Forthcoming in Journal of Banking and Finance

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