What is EFZ? (Pros, Cons, and Strategies)

Investing is not just about finding assets that grow in value but also about hedging against potential downturns. This is where inverse ETFs like EFZ come into play. EFZ can be a strategic tool in an investor's arsenal, particularly in times of market pessimism. Today, we will explore what EFZ is, its advantages and disadvantages, and some strategies for using it effectively.

What is EFZ?

EFZ stands for ProShares Short MSCI EAFE. It is an inverse ETF designed to move opposite to the price and performance of the MSCI EAFE Index.

The MSCI EAFE Index includes a broad range of companies across 21 developed markets outside of North America, including Europe, Australasia, and the Far East. EFZ aims to deliver the inverse of the daily return of this index, which makes it a powerful tool for hedging against declines in these markets.

Key Features of EFZ

• Seeks to provide -1x the daily performance of the MSCI EAFE Index
• Composed of inverse positions in futures contracts, options, swap agreements, and short equity positions
• Primarily used for short-term hedging and speculation

It's crucial to understand that EFZ is designed for short-term use due to the daily resetting nature of the inverse ETF, which can lead to significant deviations from the inverse performance of the index over longer periods.

EFZ Composition

EFZ doesn't hold traditional long equity positions. Instead, its portfolio consists of derivatives like futures, options, and swaps that collectively mimic the inverse of the MSCI EAFE Index. As such, it's more complex than your standard ETF and requires an understanding of how inverse products work.

Pros of EFZ

Hedging Against Downturns

EFZ's primary advantage is its ability to act as a hedge against downturns in the MSCI EAFE Index. If you have long positions in international equities that follow this index, EFZ can help balance your portfolio when those markets are declining.

For example, if you are concerned about economic instability in Europe or Japan, a position in EFZ can mitigate potential losses from your international holdings.

Strategic Short-Term Plays

On days or weeks when you anticipate a decline in global developed markets, EFZ can be used for strategic short-term plays. This allows traders to capitalize on downward movements without the need for complex short-selling techniques.

No Borrowing Costs or Margin Requirements

Unlike traditional shorting, using an inverse ETF like EFZ involves no borrowing costs or margin requirements. This makes it easier and more cost-effective for individual investors to take a negative view on the market.

Cons of EFZ

Daily Reset Risk

EFZ is designed to provide inverse returns on a daily basis, which means the ETF resets its exposure at the end of each trading day. Over longer periods, this can lead to significant divergence from the expected inverse performance of the MSCI EAFE Index due to compounding effects.

Not Suitable for Long-Term Investments

Because of the daily reset and the complexity of derivatives, EFZ is not suitable for long-term investments. Holding it for extended periods can result in unexpected losses even if the MSCI EAFE Index declines over that time.

High Expense Ratio

Inverse ETFs generally come with higher expense ratios compared to traditional ETFs. EFZ is no exception, carrying a higher cost which can erode returns over time if held for longer than intended.

EFZ Investment Strategies

EFZ might not be a long-term investment, but it can serve specific strategic purposes, especially around market downturns and volatility. Here are some strategies to consider:

Short-Term Hedging

For investors with significant exposure to international markets, EFZ can be an efficient way to hedge against short-term risks. By allocating a portion of the portfolio to EFZ, you can help counterbalance potential losses in your long positions when the MSCI EAFE Index declines.

Tactical Trading

Active traders might find EFZ useful for short-term speculative trades. If you have a strong conviction that the markets represented by the MSCI EAFE Index are set to decline, EFZ provides a means to profit from that downturn without engaging in complex short-selling.

Portfolio Diversification

Although EFZ should not be a permanent fixture in a portfolio, it can offer diversification benefits during times of market stress. By temporarily including EFZ, you can mitigate the volatility of international equity holdings and smooth out overall portfolio performance.

Monitoring and Adjusting

Given the daily reset nature of EFZ, it's crucial to monitor your position frequently. Ensure that you adjust your holdings to align with your short-term market outlook and risk tolerance. This active management is necessary to mitigate the risks associated with holding inverse ETFs longer than intended.

Conclusion

EFZ can be a powerful tool for hedging and short-term trading in international markets. However, its daily reset feature, high expense ratio, and unsuitability for long-term investment make it crucial for investors to understand its workings fully. By employing strategic short-term hedging, tactical trading, and active management, EFZ can play a vital role in protecting and potentially enhancing your portfolio during turbulent times in global equity markets.