One thing that struck me, even before the current market downturn, was how highly correlated worldwide investments are. You could be long Retail, long Healthcare, long U.S. Index funds, long Technology, long Asia, long Africa, long Gold - and they still all moved together: if one was up, they were all up; if one was down, they were all down.
Clearly diversification alone did not avoid significant losses in the current market downturn. You would think “I’m diversified by market segments, by geography, by technologies, by … " and when the market went down, there was no place to hide.
More powerful portfolio protection is called for and finance has a term for it: Negative Beta. Negative Beta means an investment that goes up when the rest of the market goes down.
Below are some negative beta, hedging, and other techniques that can mitigate losses in a down market. I am not saying you will have no losses in a down market, but these techniques can enable you to stay fully invested (to be in the market and prepared for upturns) and not be totally wiped out when the market turns down. Negative Beta and hedging techniques can also be used to reduce risk in specific investment situations like a 401k Cash Out and those are discussed below.
The techniques below are useful for hedging or protecting equity (stock and stock based mutual funds and ETFs) portfolios; they are not necessarily effective for bonds or other fixed income investments.
With all investments, timing is critical. Here are the situations when you should consider the negative beta, hedging, and loss protection techniques discussed below:
- You have a large degree of concern the market may fall a substantial amount (40% or more) from it’s current levels. The Armageddon Puts discussed below can help you in this situation.
- You have specific financial commitments coming up that require your investments to have a certain value at a given time - a loan due, you want to buy a retirement home, your children are going to college.
- You have large gains in your portfolio that you want to protect. Hedging is a way of making sure the outcome falls in a given range by making simultaneous negative bets to counterweight your positive bets.
- You have assets that you don’t physically control yet but you have large stake in their future value. Examples would be exercising stock options from your company at a future date, or owning a 401k plan that you want to have a certain value a year from now when you withdraw it, or inheriting stocks and the executor won’t convert the account into cash for you until you formally inherit it.
- When you keep hearing “The Dow hit all time high today …" on the radio and you can’t afford to wait out a market recovery if the market does drop substantially. It may be a while before we get back to this radio message again.
Negative Beta, Hedge, and Loss Mitigation Techniques
Be Short Up to 10% of Your Portfolio: There are two kinds of investment ideas in the market, long ideas and short ideas. Most of us explore only the long side of things. If you are a better than average investor, your ideas about what may drop are probably as good as your ideas about what will rise. It’s not a bad idea to have at least a few shorts/puts going in your portfolio anyway and when the market takes a turn like it did in October 2008 they provide you with a few green lines in your portfolio view when all the other lines are red. I generally recommend shorting to puts for two reasons:
- puts require precise timing which is tricky for most investors
- puts are not as widely traded as common stocks and you can buy and sell at bad prices if you aren’t familiar with how options work.
If you are afraid of shorts and puts, take some money you can afford to lose and try it once on a small scale just to understand how it works. If you are really good, the market may rise and your shorts still make money, or you will make extra money on your shorts when the market is falling. When you short an investment you already hold, you lock in the gain on the investment up to that point. It is generally not wise to be long and short the same investment at the same time. There are times when this is useful though. If you are an employee of a company and receive stock options, you can lock in the gain of those options before you are allowed to exercise them by short selling them ahead of time. When you are allowed to exercise the option you do so, receive the shares, and close the shares out against the box of your previous short sale. (caveat: many companies have restrictions on employees shorting their companies’ stock). If you inherited stock and the executor wouldn’t let you sell it until you formally receive your inheritance, shorts would be a way to “sell” the inherited stocks at the current market price before getting control of it.
Armageddon Puts: The fact that the market is highly correlated, as was mentioned above, can be turned to our advantage. If you have a well diversified portfolio you can buy pretty good insurance against catastrophic loss by buying an out of the money (20% or 30% below current market levels, a year out in expiration) put on the S&P 500 or some other major market index. The last time the S&P 500 was at or above 1500 you could have bought a put on a million dollars worth of the S&P, with a 1200 strike price, and a year out expiration date, for approximately 23 thousand dollars (the price for a year out, -30% put has gone up now to about 30 thousand dollars). You would accomplish this by buying a 30% out of the money put on SPDRs (SPY) or iShares S&P 500 (IVV). This put would have paid you approximately $220,000 in short term gains at the end of October of this year. If the market had gone up, your put expires worthless as a short term loss, but your portfolio went up and you are still in a positive position. The Armageddon Put is like buying insurance against catastrophic loss in your portfolio.
Index puts are not fool proof and you should not use them constantly. The market could go down to just above your strike price, but then your long portfolio is still at 70 to 80% of it’s prior value. There are also tax implications of this technique you should be aware of. All puts and shorts are considered “short term”. My sources tell me short term gains (the put) can be netted against long term losses, so with a little planning (you sell off setting losses before the end of the tax year) an Armageddon Put can be tax neutral. This technique is complicated and tricky, make sure you are talking to a knowledgeable index options person at your brokerage if you are considering implementing it.
Ultra Short Funds: The animal spirits of the free market have made it much easier for the retail investor to go short than was previously the case. Ultra short funds are another short technique that can be used to make up the general 10% short I am recommending. Financial wizards have created funds that you buy like any ETF that are short indexes or sectors. For more information about these ETFs (examples Proshares Ultra Short Real Estate (SRS), Proshares Ultra Short Financials (SKF) and Proshares Ultra Short Technology (REF)) see here. Pay particular attention to the Sector ETF options. I’m sure there are other companies than Proshares for ETF short vehicles and readers can share those names in the Comments. The “Ultra” refers to financial manipulations Proshares does to exaggerate the effect of the security. With “Ultra” if the index goes down 5% the corresponding ETF will go up 10% in most cases. These Ultra ETFs have another important advantage. You can’t short stocks or buy puts and calls in a self directed standard brokerage IRA, but you can buy these Ultra ETFs in an IRA. It gets even better. Even though this Ultra investement vehicle is short, which is typically ordinary income tax treatment, if you hold these Ultra investment for more than a year they get capital gains treatment.
So to make the use of Ultra Short Funds more concrete, I will share my personal experience with Proshares Ultra Short Real Estate (SRS). The general approach here is to sell all long investments you hold in a sector and then buy the corresponding Ultra ETF to short the sector. Since most sectors are highly correlated you will surely benefit from this approach in a down market. I became concerned in the spring of 2007 that REITs had gotten ahead of themselves. REITs used to be a solid income investment that gave a 5%+ dividend and had some upside potential.
But REITs got caught up in the real estate euphoria and many of them had increased 100% to 200%, driving the yields down to 2% or 3%. When a financial writer I respect highly said the commercial real estate market had hit it’s peak, I decided to act. I sold all the REITs and real estate mutual funds / ETFs in my portfolio.
You don’t want to be long and short the same things at the same time so it is important to sell all direct long investments in the sector before you buy the Ultra ETF. I bought the Proshares Ultra Short Real Estate ETF (SRS) and I will say this about it: it’s gone up 40 point in one day, it’s gone down 40 points in one day, but very consistently when the market is down it is more than up, when the market is up it is more than down. In my case due to a generally down market and an extra drop in REIT shares, my gains on srs offset some of the losses on my generally long equity portfolio.
Trailing Stop Loss Orders: Most online brokers have a feature that will allow you to put in an order that will sell an investment if it drops past a certain point. The “trailing” feature is an augmentation to this that allows you to set a percentage drop over the all time high that sets when you want to sell. I believe the general use of Stop Loss orders enabled by superior computing power and used by larger percentages of the investing population, may be partially responsible for the huge drops we saw in equities in October of this year. Some external source knocks the market down and this trips all these stop loss orders by professional and retail investors and down we go. As the market drops more people get nervous and put in more Stop Loss orders. But we’re not here to fix the worlds’ problems we’re here to give you tools to protect yourself in a down market. You may feel that you are a buy and hold investor. You may think you have a good idea and you’re willing to wait 7 or 8 years for your investment to bear fruit. I am asking you to consider putting a Trailing Stop Loss on any investment you hold that that doubles in two years or less.
“Hot” money makes investing cycles much faster than they used to be previously. I want to give the stock Sociedad Quimica y Minera (SQM) (Chemical and Mining of Chile) as an example. SQM is a South American mining company that is an important source of Lithium which can be used in car batteries. The investment idea was that electric cars would grow in number and that lithium would be an important component in those cars. In calendar year 2008 alone, SQM went from 15 to 55, crashed to 15 again and is now in the low 20s. Where was the time to see SQM convert its lithium production to go to car batteries, for electric cars come into common use, and for the investment to reflect good planning and show a good return? All that was blasted away by hedge funds, internet blogs, Cramer’s mention of the stock, and the panic out of commodities when oil dropped. If you have a good idea and the market agrees with you sooner than you expected, protect your gains with a trailing stop loss order.
Hold 10% Negative Beta Investments: There are investments that are not short or put investments that go up in value when other investments go down. These investments are rare, and a negative beta investment that worked 10 years ago may not work in the current situation. In the October downturn, two classic negative beta investments, gold and commodities, failed to perform their negative beta duties. I am suggesting that you hold 10% of your portfolio in negative beta investments.
The hands down winner for negative beta investments in the October downturn were fixed rate U.S. Treasury securities. In spite of the fact that the U.S. led the world into problems with the sub-prime crisis, when the chips were down the world rushed into U.S Treasury securities. I’m not suggesting that you run out and buy U.S. Treasuries at the current time. Many knowledgeable pundits think that the Bailout and other financial obligations of the U.S. government will cause the U.S. to have to issue more debt and print more inflation causing money. This should cause U.S. Treasuries to lose principal value. But over the next few years, if you see attractive entry points for U.S. Treasuries, buy and provide your portfolio with some negative beta capability. Surprisingly U.S. TIPS (Inflation Protected) have fallen in bond value over the last year. Maybe some reader has some insight into that.
Another surprising negative beta investment in the October downturn was the Japanese Yen; not the Japanese stock market, but the Japanese Yen. A retail investor can buy the Japanese yen with the Rydex Japanese Yen ETF (JPY). The carry trade unwound and the world rushed to buy the conservative, low local interest rate, Japanese currency. The Rydex Swiss Franc (FXF) is also mentioned as a currency that people turn to in troubled times. These Rydex currency funds do pay interest but it is small, also there is some obvious limit as to how much a currency can move in your direction, so currency hedges have to be timed.
You would think that certain businesses would be good negative beta investments, like bill collectors or a law firm that specializes in bankruptcy but I haven’t been able to find any securities that I could buy that worked well as negative beta. We should use a computer to search October performance and find some negative beta investments.
Use Self Directed Accounts to Hedge Your 401k: Companies do their best to provide their employees with meaningful investment options in the 401k plans they offer employees. But best case you will get maybe 20 investment choices in your company's 401k. This means you are stuck with the investments your company offers and you have no ability hedge or buy negative beta assets that could smooth out your 401k investment return over time. The idea here is to use your self directed IRA and/or taxable brokerage accounts to hedge your 401k. Obviously you have to have the investment infrastructure such that you have a self directed IRA and/or a taxable brokerage account to perform your hedges. The best vehicle for hedging is a taxable brokerage account with enough money to be able to short, buy puts, buy Ultra short funds, and buy negative beta investments. You have to plan for this, open a taxable account, and save the money so you have to the resources to execute your hedges. A self directed IRA will let you perform some of these hedging functions also.
I want to start with a few general pointers about 401ks. First, if you have a chance to convert a company 401k to a self directed IRA, always take it. If you like the investments you had in your 401k you can buy them again in your self directed IRA, plus you have the myriad of investment options that any online brokerage offers nowadays that can be important for hedging and other investment strategies. Second, in general don’t buy investments in your self directed IRA and taxable accounts that you can hold in your 401k. Since you are forced to buy only certain investments in your 401k, load up those investments in your 401k and use your self directed accounts to hedge and diversify your portfolio.
In most 401ks you can buy stock funds and bond funds. If you are lucky you may be able to get some geographic diversification (foreign stocks) but your choices are going to be very limited relative to a self directed account. If you like your job and hope your 401k will be in the same place the next 10 or 15 years, any chances to hedge inside the 401k are non-existent. You should include your 401k in the equity and bond portion of your portfolio and include the amount of your 401k in computing the amount of hedge you want to build for you portfolio by shorting stocks or holding negative beta assets. So for example suppose you have 200k of taxable accounts, 400k of IRA’s, and 400k of 401k money. To meet your portfolio protection goals you would strive to be short 100k and hold negative beta assets of 100k as well. Your 401k might let you hold mutual funds of U.S. government securities but in general you would hold your negative beta and shorts in your self directed accounts.
A special case comes up when you know that you are leaving the company and you want to make sure the amount you withdraw from the 401k maintains its value when you take your 401k distribution. Most 401ks have a short term bond fund option, this should be treated as cash if your 401k fund doesn’t have a money market option which most don’t. If you felt your current 401k balance met your goals and you were going to take your 401k payout a year out, one option would be to move all your balances into the short term bond fund and wait for your payout. This can be trickier if your 401k doesn’t have a cash equivalent option or the fund restricts changing the mix of your 401k to once a quarter or once a year. In that case you could use some of the shorting or putting options discussed above to lock in the current value of your 401k a year ahead of time.
Read Contrarian Financial Writers: Reading contrarian financial writers has two positive benefits for an investor interested in protecting their portfolio in all kinds of markets. First, they are a wealth of ideas on sectors, companies, or currencies that are good short/hedge opportunities in the current environment. Second, they raise your antennae to the possibility that the market will be making a turn and that you need to be beefing up the short and negative beta portions of your portfolio. Steve Hanke and Gary Shilling of Forbes are very good examples of contrarian financial writers. James Grant of the Grant Interest Rate Observer is a very good contrarian writer, but you have to pay to read him now. In the blogsphere, Karl Denninger was very early on to the real estate bubble and the problems with Fannie Mae and Freddie Mac.
Conclusion
A diversified portfolio alone did not protect the average retail investor in this latest market downturn. The purpose of this article was to give the retail investor some tools to use that allow the investor to stay fully invested, use hedging techniques in specific situations, and allow the investor to protect some of the value of their portfolio in a down market. If some of the tools discussed here seem complicated, consult a financial advisor experienced with the techniques to make sure you are getting your intended investment. These are trying times, good luck with the tools and good luck with your investing.
Disclosure: The author is long SRS, FXY, FXF
