Benefiting from Simple Hedging Techniques (Part I)

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 |  Includes: EEM, EFA, IWM, IYR, QQQ, SPY, XLB, XLF, XLI, XLK, XLP, XLU, XLV, XLY
by: MyPlanIQ

Amid the euphoria on possible economic recovery, most major stock and debt markets have risen in an almost nonstop fashion since June of this year. This presents a heightened anxiety among many prudent investors: will there be another leg down if the rosy picture about the economics turns out to be premature?

Given the high level of stock markets at this moment (not to mention now we are entering September, usually considered to be the worst month for stock market), this is especially important. From reviewing various strategies on ValidFi.com, we could learn a thing or two.

One conclusion could be drawn from comparing the performance and risk of many ValidFi's strategies and various mutual funds: you don't need to take excessive risk to earn a stable decent return. In fact, many outperforming strategies have much lower risk but higher return compared with those risky strategies such as a simple buy and hold of stock equities or risky bonds. Readers could look at ValidFi's time tested strategies to get a glimpse of this.

One pertinent type of strategies could be useful in current situation is portfolio hedging. In this article, we review several simple hedging techniques.

The first and the easiest way to hedge is to simply hedge the equity portion of a portfolio by shorting major index or multiple indexes based ETFs such as SPY, IWM, QQQQ or EFA with the same amount. This applies to other risky parts of your portfolio (for example, if you have 20% REIT stocks, you could try to short Dow Jones US REIT Index ETF IYR by 20% amount, beware that to short a narrow index based ETF such as IYR is not always possible, especially during market stress). This technique makes sense if you believe that your equity or risky part of portfolio will outperform the corresponding index. Your main return or loss would be the difference between your portfolio portion return and that of the ETF you short.

For example, ValidFi maintains a portfolio which has the monthly adjusted portfolio of strategy Sector Rotation on Fidelity Select Funds as its long position and 100% short SPY as the hedge (the short position is adjusted monthly). The following table compares performance between the unhedged and hedged portfolios up to 8/27/2009.

Last 1 Year (%)

Last 3 Year (%)

Last 5 Year(%)

Since 12/31/1993 (%)

Annual Return

Hedged

8.047

5.866

11.94

8.532

Long Only

-8.767

1.032

12.887

19.648

Sharpe Ratio

Hedged

38.992

21.826

51.569

32.322

Long Only

-24.147

-2.398

40.428

73.148

Standard Deviation

Hedged

20.131

18.964

19.305

18.718

Long Only

37.123

28.952

26.969

23.415

Maximum Drawdown

Hedged

20.352

20.352

20.352

39.947

Long Only

35.411

47.529

47.529

51.111

Click to enlarge

From the above, one could see that the hedged portfolio has about 20-40% standard deviation reduction and much higher annualized returns.

It should be noted that the above full hedging method has a major risk: why your long portion of the portfolio (severely) underforms the ETF(s) you are shorting, substantial loss could be incurred. Another twist of this is to hedge partially, such as 30% or 50% of the risky portion. Such portion of the portfolio should still be viewed as risky portion with dampened volatility.

This technique has a major advantage over the fully hedged one: in the event of the significant under performance of long portfolio compared with the short ETFs, you still will not incur much loss or no loss at all as your long portion is still having a positive delta (a geek term which could be simply interpreted as the long amount minus the short amount. To be even more precise, it should be the long beta minus the short beta).

On the flip side, such hedging certainly can not fully hedge against a severe downturn.

Interested readers could refer to the 30% short hedge Sector Rotation on Fidelity Select Funds portfolio from here.

In the next installment, we will discuss two more effective ways to hedge.

Disclosure: No positions.