Hedging (and ETFs)
So, you think you got what it takes to be a big shot hedge fund manager? Well, with ETFs at your disposal, you can practice similar hedging tactics as many hedge funds in your own portfolio. Now, let’s get something clear, a hedge fund is an investment fund which practices hedging as a way to manage risk. A hedge fund is not just any unregulated fund which can do things like put all your money into oil futures. Granted, that’s what the term “hedge fund” has come to mean these days, but, if I’m correct in my understanding, these funds are legally classified as “investment partnerships.” I’m tired of the hedge fund misnomer and word “hedge” having a connotation of “risk” when, in fact, good hedging is meant to reduce risk.
The simplest way to hedge is to take both long and short positions in your portfolio. The idea behind this is that, in general, a rising market lifts all ships and a falling market sink all ships. For the most part, this is true. As a result, having both long and short positions will limit our portfolio’s response to swings in both directions. Yes, in both directions. Hedging is not a magical answer to higher nominal returns. In actuality, a good hedged portfolio will more often than not trail a rising market. The key, though, is that a very well hedged portfolio will lose very little or even make money in a falling market. That’s the beauty of hedging. If done correctly, you can limit downside quite significantly and, for many, fear of loss trumps greed for gains.
Now, your first instinct may be to buy a position in a company you like and take a short position on a company you think is going to tank. Not bad. That’s the general idea of hedging. Heck, if you’re really good, maybe both will work out for you and you will actually generate seriously market beating returns. Unfortunately, very few people are such good stock pickers that they can just selectively buy and short different companies’ stocks for profit. If you happen to buy and short two stocks which are completely uncorrelated (one goes up while the other goes down), then you have the chance of either making a lot of money or losing a lot of money. Doesn’t sound like great risk management to me.
The key to good hedging is to make your long and short picks on positions which are correlated. This allows for predictable behavior and gives you the highest chances of the hedge working to reduce risk. Now, you might be thinking, “why the heck do I want correlated investments for a long and a short?” You might have even deduced the logical extreme of such a statement. After all, every investment is best correlated with itself, but if we bought “stock A” and shorted “stock A” at the same time, there’d be no money made. Actually, there’d be money lost on commissions.
The key to buying and shorting positions with correlation is that the short position should lag the long position but generally travel in the same direction – the short position won’t increase as fast as the long position but decrease faster than the long position. How would this work? One could imagine purchasing an undervalued stock while shorting its industry’s ETF. In this case, the undervalued stock should appreciate more than its industry as a whole, but, since it is undervalued, if the industry goes south for one reason or another, the undervalued stock should have less to lose.
If you were equally weighted in your long and short, you would make money in either case! If the market appreciated, the short on the sector might lose money but it would lose less than the money you make on the stock pick. If the market declined, the short on the sector would make more money than you would lose on the stock. Great deal, right? Well, yes if you’re willing to give up some the returns you would have been able to make had you known to go entirely long or short one way or the other. I think most of us would be able to admit we likely can’t predict which way a market will go and willingly accept such a trade-off.
The hedge described above is known as a market neutral hedge, a hedge which ought to work regardless of the direction the market heads. This can be accomplished in a few different ways. As a paired trade, you buy and short equal amounts of two stocks. Buying the one you expect to outperform the other. For many, this is easiest done by buying a particular stock you like and shorting its respective industry or shorting the market index all together. This strategy probably works best for those who practice investing based on “relative value” (i.e. price to earnings versus industry) as that’s exactly what this hedge is meant to do – capture the relative outperformance or underperformance of the securities you pair together. Another way to accomplish a market neutral hedge is through a dollar neutral portfolio. In this case, you buy equal dollar amounts worth of short and long positions. For example, you may like three stocks to outperform the broad market and buy $1000 worth of each of them. A dollar neutral hedge would require a $3000 investment in a short on the market (i.e. S&P 500) to balance the $3000 you put in long positions.
One of the bonuses of new ETFs, particularly those offered by ProShares, is that there are now leveraged ETFs which give you more exposure to the market (long or short) for each dollar you pay. For example, if you bought the Proshares Ultrashort S&P (symbol: SDS), you would get two times the return when the market falls (or two times the loss if the market improves). As a result, you don’t necessarily need to be dollar neutral when you invest and it allows you to put more money in your longs while maintaining market neutrality. You may have noticed that I said, buy the Ultrashort S&P ETF for your short position. Here is another bonus of ETFs. Since we now have inverse ETFs, its not entirely necessary to short ETFs to gain short exposure. Some fund providers are already rolling such exposure into the ETF. Granted, the offerings aren’t as diverse as long ETFs, but, for those of us who don’t have margin accounts, these ETFs provide the ability to apply hedging strategies we otherwise wouldn’t be able to.
Now, maybe you don’t want to be market neutral. Maybe you’re bullish and you’d like to be maintain a long bias (have more money invested in long positions). Or, maybe you’re bearish so you’d like a short bias. In this case, using ultrashort or double inverse ETFs can allow you to use a small amount of money to generate a lot of downside protection exposure one way or the other. I won’t go too much into long and short bias hedging as it is a bit more difficult than market neutral hedging. If you ask me, if you’re biased one way or the other, you might as well bet the ranch on the market rising or falling, there’s no reason to be slightly hedged in the other direction. The risk management gets too complex when you aren’t looking at our investments as pairs and have to judge each for its own merits. As a result, it becomes more difficult to effectively hedge away risk and, at the same time, any amount of hedging will cut into your profits. If you do lean towards a long or short bias, then invest with conviction and don’t bother with a partial hedge! Practicing disciplined risk/loss management (i.e. hard stop losses and clear profit taking goals) will protect you almost as well.
If you enjoyed this post, please consider to leave a comment or subscribe to the feed and get future articles delivered to your feed reader.
