Let me begin by suggesting that any reader who finds short selling (or buying short ETFs, etc.) to be "wrong" or "immoral" should move on to another post or article, as you'll only get upset.
A couple of years back, Warren Buffett made a wager that the S&P would show a better return over the span of a decade than a fund of hedge funds would. In 2007, hedge funds handily outperformed the S&P, as the approaching tail end of the bull market, combined with leverage worked their magic.
In 2008, despite the fact that many people had developed the idea that all hedge funds were absolute return vehicles immune to market declines, hedge funds, as a group, DID decline on the order of 20%, but that’s still a considerably better showing than was managed by the S&P. Even though 2009 still has a few weeks to run, it appears to be on the order of a dead heat. In all, for the first three years of the decade, hedge funds, as a group, are noticeably outperforming the S&P.
There’s probably more than one reader who’s thinking, “Well, that’s just peachy, but what does that mean to me? I’m nowhere close to being a “qualified investor”, so however it is that hedge funds manage to do their thing, I’m not able to participate.” To those readers, I’d suggest its entirely possible to come pretty darn close to replicating their performance, even if many of the techniques used by funds are not available to retail investors.
I should note, at this point, that I’m referring to the “absolute return” category of funds, which means they’re willing to forgo some measure of capital appreciation in order to ensure capital preservation. As in most areas of life, having your cake and eating it, too, is not a viable option. For many investors, such as myself, who are managing a retirement portfolio, and are either fairly close to, or in retirement, that’s the goal, usually in conjunction with generating a fairly appreciable amount of income. There’s no shortage of stories of people who thought they were in good shape financially until 2008 reared its ugly head and decimated their portfolios, along with the value of their homes. But if they would have taken appropriate steps ahead of time, in terms of using hedges, for the most part, its likely they would be in much better shape today.
The use of short ETFs can make a marked difference in portfolio performance, in terms of dampening volatility and preserving capital. I’ve had success using SDS as a partial hedge and I started wondering how I could be a bit more “precise” in my hedging, tailoring my hedges more closely to my portfolio. One area that I’ve had exposure to in varying amounts, ranging from “overweight” to “heavily overweight”, is oil, via Canroys. While they throw off a very respectable amount of yield, they tend to track oil (and sometimes NG, depending their production mix) prices, and can be pretty volatile. I have not yet gotten around to back testing but it has occurred to me that a position in DUG, for example, could act as a counterweight, stabilizing the capital value of the portfolio, while still allowing me to enjoy the higher yields.
Another sector that appears might be suitable to such a strategy might be REITs, where SRS would be used as the hedge. Of course, such hedging only helps preserve capital while doing nothing to mitigate loss of income should the securities cut their dividends, as happened with quite a few REITs. Still, I’d look at it from the standpoint of “half a loaf is better than none”.
Disclosure: Author holds a long position in SDS
