Until the 2008 stock market meltdown, I’d never attempted to “hedge” my portfolio. Common wisdom was that there is safety in diversification and asset allocation.
As it turned out, most asset classes are correlated to each other in a severe bear market, so that when things turn sour, stocks in Asia fall, stocks in Europe fall, stocks in North America fall, etc. Even supposedly “alternative” asset classes, such as real estate or real estate investment trusts, commodities and precious metals, tend to fall with broad-based equities.
In 2008, the only safety was in cash or bonds. But there is another asset class that’s completely uncorrelated to stocks: reverse index funds or reverse exchange-traded funds or notes (ETNs). If what you want is an investment that goes up when stocks go down, then reverse funds fit the bill perfectly.
There are ways to use put-and-call options on the major stock indexes (primarily the S&P 500) to hedge a portfolio, but this is difficult and means you’ll need the help of an adviser who is familiar with options. Reverse funds are easier to use.
The key concept in hedging is to think of it as insurance or putting a “floor” on your portfolio value. Like all insurance, there is a cost to achieving peace of mind.
Let’s say you have a portfolio worth $1 million. It’s diversified: 60% stocks and 40% bonds. You’re concerned about hedging $600,000 of your stock exposure from a catastrophic market crash. You reason that you’re willing to give up some upside in return for minimizing the downside. It’s more important to you that the $600,000 doesn’t fall to $300,000 than it growing to $900,000.
So maybe you decide to “hedge” 50% of your stock exposure, which means you want to protect $300,000. By using a reverse index fund with triple market exposure, you don’t have to buy $300,000 worth – just $100,000 worth. So you sell $100,000 of your $600,000 stock portfolio to purchase the triple leveraged ETN.
Now if stocks crash and the remaining $500,000 stock portion of the portfolio falls to $400,000, your ETN will rise by perhaps $50,000. (You’re only partially hedged.) But your bond portfolio is also rising and you’ve lost a lot less than those who never tried to hedge at all.
You could of course opt to pay more insurance by hedging 100% of your stocks, but then you won’t be happy if markets keep rising. You’ll be breaking even while your bullish, non-hedged friends make a lot more. Since markets rise two-thirds of the time, you might choose to be two-thirds hedged if you think markets over overvalued and due for a fall.
It’s all about risk tolerance, tradeoffs and being able to sleep at night. Done right, though, hedging is actually conservative and not the high-flying speculation some fear it is.