The Long and Short of Hedging

The U.S. credit rating has just been downgraded to AA+ by Standard and Poors, after being put on credit watch just a little over a week ago.

In a “normal world”, this would increase the cost of capital not only for the U.S. government, but for most other borrowers in the U.S.  (including corporations, mortgage borrowers, small businesses, etc.).  With the appearently unlimited lending power of the Federal Reserve, it is difficult to say if  the standard rules still apply.

Nonetheless, one of the metrics used in the valuation of the stocks is something called the “risk-free rate”.  Essentially, this is the return that you can get in a “riskless” asset.  Traditionally this has been based on the yield of U.S. Treasury Bills.  If the risk-free rate goes up, the value of stocks typically goes down as Price/Earnings multiples get compressed to create a more level playing field between the earnings yield of stocks and coupon yield of bonds.

There will be some confusion over the next few months, because nobody knows what a risk-free asset is anymore.

So, in this post, I felt that it might make sense to share a strategy with you that I’ve been using in my own accounts for a few months now – hedging… 

Essentially, a hedge is a type of investment that earns money to offset the losses of another investment.  Think of it as a type of insurance policy.  Most of the time, you hope that it doesn’t work, but you are glad to have it when you need it.

There are many ways to hedge.  Futures contracts and options are among the most common. For ease of implementation, inverse funds and ETFs are easier to understand and use.  On a daily basis, inverse strategies hope to give the exact opposite returns of their underlying investment.  If the S&P 500 goes up 1%, the inverse strategy should lose 1%.

ETFs trend to trade on a minute-by-minute basis.   Conventional mutual funds only trade at the end of each day.  So, in this category, ETFs are my preferred vehical.

Currently, I am using ProShares Short S&P 500 (ticker:  SH) to offset the risks of my core stock holdings.   There is also the ProShares Short QQQ (PSQ) which inversely tracks the performance of the Nasdaq.  ProShares Short Russell 2000 (RWM) goes in the opposite direction of most small cap stocks.    ProShares Short MidCap 400 (MYY) does the same for mid-cap stocks.

Why wouldn’t you just sell and go to cash?  Well, if you did that, you would have to pay capital gains on all of your sales.   This could be a problem if you have stock with a low cost basis (particularly for taxable accounts).  Hedging enables you to offset some your market exposure without selling stuff.

Also, if you are a good stock picker and your companies do better than the market in a downturn, then you could make more money by hedging than you would by simply selling.  If the market goes down 8% and your stocks only go down 6%, you can keep some of the dfference.

Last note on the pitfalls of hedging — there are at least three.

First:  You could be wrong about the direction of the market.  A hedge will cost money in a rising market.

Second:   If the hedge is profitable, it will generated taxable gains when closed or sold.

Third:   Hedges need to be periodically trimmed and adjusted.  Inverse ETF’s in partcular tend to be more accurate over shorter time frames.

For more permanent re-allocation of a portfolio ( say over 3 to 6 months) it might make sense to trim investment holdings — starting with investments that can be sold at a loss, or stocks that do not pay a dividend.

With everything else in life, there are no guarantees.  There are, however, appropriate ways to manage risk.  So, it is important to use solid judgement and know your plan…

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One Response to The Long and Short of Hedging

  1. Hal says:

    Hey, I like how the investment job is in similar terms with landscaping….”trimming the hedges” is required from time to time. 🙂

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