Sunday, March 9, 2008

Strategies To Hedge Your Portfolio

Need insurance?
Do you wish you had portfolio insurance? Some way to reduce your exposure to the market downturns. Good news is that options do exist to reduce your risk and protect your portfolio during adverse market conditions. Listed below are five strategies you can consider

Strategy # 1: Options
Simply stated - options are financial contracts that give you the right or obligation (contingent on buying or selling the contract) to buy or sell the underlying security within a defined time period. Options are the insurance equivalent of the financial world. Options can provide complex and leveraged trading opportunities but for portfolio hedging what you seek are PUTs. Specifically, owning PUTs is one way to mitigate portfolio risk.

A PUT gives you the right to sell the underlying security at a predefined price. Consider the following scenario:
- Portfolio value = $13,000
- Portfolio investment = 100 shares of S&P 500 ETF (SPY) @ $130/share
- Dec 2008 PUT @130 premium = $11.40
- PUT contract required to protect the portfolio = 1 (which equates to 100 shares of SPY)
- Total cost of PUT = $11.40 x 100 shares = $1140/contract
- Premium % = $1140/$13,000 or about 9%

This option coverage, which is costing you about 9% of your total portfolio value, will offset any drop in your portfolio through end of the year. You have the option to sell your position at any point in time (before expiry in Dec) and claim any remaining premium in the option (more premium if market is down and less if market is up). This strategy can provide 100% coverage (minus premium) but can be expensive.

Strategy # 2: Shorting
Shorting is the converse of buying stock. Specifically, you borrow the shares and sell them. If the share price drops then you can buy the shares at a lower price and return to the borrower - pocketing the difference as profit. If the shares rise in value then you get 'short squeezed' and will eventually have to 'cover' by buying the shares at a higher price thereby incurring a loss.

If you are bearish on the market, you can consider shorting the market. This strategy offers downside protection but there is the question of funding the position. Shorting requires the same financial investment as buying stocks/shares so to short the market; you will have to liquidate some portion of your portfolio. A 100% hedge against any market downturn is achieved by investing 50% of your portfolio in a short position. This will effectively balance the up with the down leading to a static portfolio. Cost of selling, buying equities and any corresponding tax consequences need to be considered.

A 100% hedge insulates you from market gyrations but also reduces your exposure to any positive moves in the market. Basically your investment is inert till you change the short/regular holding ratio. If you want limited downside in your portfolio for a while you might consider high-yield savings accounts, CDs or money market positions. These options are low risk and provide some investment return in the form of interest income.

Strategy # 3: Diversification
An appropriately diversified portfolio can offer some level of hedge against market fluctuations. Diversification is a broad and diverse subject since investment options galore. The popular diversification technique is stocks, mutual funds, bonds and cash in a proportion tied to your risk preference. Even in this allocation model you can micro diversify across size, sectors, growth and global footprint. But why stop at US equities. Consider emerging markets, real estate investments (US and offshore), commodities (oil, gas, wheat, corn etc) and gold/precious metals. If you are more adventurous there are frontier markets, options/futures trading, currency futures, complicated derivative strategies (some available as ETFs now), oil wells and small business - to name a few.

This strategy works well when one holding in your portfolio offsets performance fluctuations in another part of your portfolio. When stocks are down then the bond holding might do well, when the US market suffers an economic downturn then the emerging market may hold up well, when global markets suffer then commodities might surge ahead. There are no absolutes in this space but a diversification model that suits your market preferences and risk requirements is how you hedge your portfolio using this strategy.

Strategy # 4: Cash Only
This is an obvious option when the going gets tough. The biggest challenge with this option is the ability to time the market. The ideal scenario is cash when the market is crashing and invested in the market when the market is rising. Ideal but hardly a feasible strategy that can be consistently implemented. If you want your portfolio to be invested in cash - consider CDs, high-yield savings accounts and money market accounts.

Strategy # 5: Time
If you have a well-diversified portfolio and a long-term time horizon, your best hedging strategy is - do nothing! Invest regularly, monitor your portfolio, diversify, re-allocate as necessary and bid your time. Over long periods of time, the US stock market has returned an average of 10% annually. If your portfolio includes some emerging markets, some commodities, some real estate - you are optimistically looking at above 10% gains.

Time buys you average return by getting you away from market fluctuations and panic buying or selling.

As the market fluctuates and hype about 'doom & gloom' spreads, it helps to have a hedging strategy for your portfolio. After all prudent advice is to insure everything of value - why not your portfolio?

CBOE - Buying Index Puts to Hedge the Value of a Portfolio

CS Monitor - Frontier markets lure – and reward – hardy investors
SmartMoney - More Investors Are Using ETFs to Short the Market
Digerati Life - 8 Different Ways To Diversify And Manage Risk
Get Rich Slowly - Which Online High-Yield Savings Account is Best?
Investing Lessons - Should you be investing in emerging markets?

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Dorian Wales said...

Good post. No doubt hedging is important for any portfolio. Just don't be temped to make money with derivatives and shorts since you just might lose everything.

Anonymous said...

Absolutely first grade post!