How To Protect Your Portfolio Now

 |  Includes: DB, FXE, IPF, JPM, SAN, WFC, XLF
by: Efficient Alpha

By Joseph Hogue, CFA

I use two strategies to manage my portfolio of investments. The first strategy is a general approach to how I allocate my money, called a core-satellite. I detailed the approach, along with another strategy that works and one common strategy that does not, in a prior article. Basically, the bulk of my investments are in index-like funds built around various return drivers. The rest of my portfolio is built around individual trades but held for a minimum of one year.

The other strategy by which I manage my portfolio is a shorter-term hedging strategy. This is my form of portfolio protection. Hedging is the purchase or sale of an asset to mitigate risks in the value of another asset. Most companies using a large amount of commodities in their production process will hedge by entering into contracts on those commodities well ahead of their calendar need. Farmers buy financial instruments to ‘pre-sell’ their crop and reduce the risk of falling prices.

I use hedging to reduce a specific risk or one that is causing systemic risk on the markets. As U.S. economic data improves and the emerging markets continue to report decent growth, the financial markets should be well into a bull market. While growth in most developed markets is not optimal, there is one region burdening the rest with systemic uncertainty, Europe. This week's market made it clear that last week’s summit and meetings were not a resolution to the crisis and volatility would remain high until a solution was found. Lately, it doesn’t matter how well you analyze a particular market or stock, as Europe goes so goes everything else.

As long as problems in Europe persist, few portfolios will be safe. To mitigate this, investors can hedge European weakness with an asset intimately tied to the sovereign debt problem, the euro. Currently trading for about $1.30 per euro, any further weakness overseas will cause the currency to depreciate. Above all this, there are also some very strong economic headwinds that will play against the euro over the foreseeable future. This outlook of weakness in the event of market trouble and limited upside makes the euro an excellent hedging instrument.

With eurozone economic growth forecasted at just 0.5% next year and little better in 2013, the region is not going to be able to grow its way out of the debt crisis. While the region may be marginally accepting of austerity measures now, I have less faith that the populace will consent to cuts for as long as necessary. Normally, when a country faces this type of crisis the solution is a rapid depreciation in the currency. The country exchanges a quick loss on their savings for increased exports and an eventual way out of the economic outhouse. While the option is not available to individual EU members, I believe it is ultimately the one that will be used by the group. Fellow Seeking Alpha Contributor, Craig Pirrong shares this view in an article Monday where he argues that the European Central Bank (ECB) has effectively pre-committed to restart the printing presses.

A Bloomberg article out Monday describes the effects of ECB President Draghi’s interest rate cuts on the currency. The ECB has been aggressively cutting rates from 1.5% earlier this year to just 0.75% and options bets are predicting further cuts. Both Moody’s and Standard & Poor’s have warned sovereigns in the region that credit ratings will be re-examined. A cut in debt ratings would make the situation worse because it would then cost more to issue and insure debt, increasing overall debt levels.

Currently, banks within the region are selling foreign assets in order to bring money back home and shore up their weak balance sheets. A June deadline has been set for the banks to comply with new liquidity rules. This repatriation of assets may temporarily support the euro but should be short-lived and ultimately cannot overcome fundamental weakness in the currency. Additionally, the fire-sale of foreign assets could further detract from growth in coming quarters.

Analysts have been cutting estimates for the currency as the crisis intensified over recent months. The Bloomberg article above cites a survey of 40 forecasts, on average lowered to $1.32 from $1.40 per euro. The overwhelmingly negative tone may lead some to believe the impetus is to the upside, but the lack of economic growth and possible future monetary easing will act to depress the currency. Technically, the euro has plenty of room in either direction. At $1.30 per euro, it is firmly in the middle of its two-year range of $1.50 set in November 2009 and $1.20 seen in June of 2010.

Though the most direct way to use the euro as a hedge would be in the currency futures market, the easiest way for most retail investors would be a short position in the CurrencyShares Euro Trust (NYSEARCA:FXE). The fund tracks the price of the euro through participation in the futures market and charges an expense ratio of 0.4%. Investors can directly short the fund or buy put options giving them the right to sell shares at a set price. As economic tensions escalate and the euro weakens, your gain on the short FXE position can be used to offset losses in other parts of your portfolio. These profits can then be invested across your portfolio to dollar-cost-average down or can be used against losses to minimize taxes.

I have actually taken a more aggressive hedge against the euro but with limited downside risk in an options strategy called a bear spread. I bought put options that expire in January 2013 with a strike price of $135 and sold the options with a strike of $130 per contract. This means I have the right to sell the fund for $135 but must buy it for $130. The strategy will cost about $2.40 per contract because you pay $10.80 for the $135 puts but collect $8.40 for the $130 puts. If the euro weakens below $1.30 by expiration, I collect $5.00 for selling at $135 and buying at $130. If the euro trades between $1.30 and $1.35 by expiration, I collect the difference with my $135 puts and do nothing with the $130 options. In reality, as stated in the last paragraph below, I would probably adjust my position depending on market movements during next year. Significant weakness in the euro would probably mean I close out the position and use the profit against other losses. Significant strength in the euro would lead me to buy back some of the sold options at a gain and just hold the long put options against future euro weakness.

Similarly, since the European crisis is primarily a financial one, investors could hedge portfolio risk through financial companies as well. I have been using a pair trade between the Financials Select SPDR (NYSEARCA:XLF) and the SPDR S&P International Financial Fund (NYSEARCA:IPF) to do this since July of this year. In an article putting banks on investors’ radar, I recognized improving economic conditions in the United States but was still extremely cynical of any solution to Europe’s debt problem. By selling shares of the International fund, with approximately half its holdings in EU banks, and buying shares of the U.S.-based financials through the XLF, I am betting on a U.S. recovery and removing some euro-related risk. Since the trade was started, the loss in the U.S. financials of -11.8% has been offset with a larger loss in the international financials of -16.6% for a net gain on the position of 4.8% (since I am short the IPF, I have a gain when the share price decreases). For those still a little uneasy about shorting stocks, see a previous article about how individual investors actually have the advantage over institutional investors when selling short.

This idea of hedging financial market risk can be carried to the individual banks as well. Banks in the U.S., Germany, and Switzerland are relatively better off than those in France or the peripheral euro countries. Though Germany uses the euro as its monetary exchange, it is in a league of its own from an economic perspective. Banks with relatively stronger positions may include Deutsche Bank (NYSE:DB), JP Morgan (NYSE:JPM) and Wells Fargo (NYSE:WFC) while a weaker bank available to hedge might include Banco Santander (STD).

Though Wells Fargo is 22.8% off its 52-week high, the bank is relatively strong compared to its U.S. peers and pays a dividend of 1.8%. The bank recently won number one in customer satisfaction for the third-straight year as ranked by the American Customer Satisfaction Index (ACSI).

JP Morgan is further off its highs with a 33.3% drop since the 52-week peek, but also relatively healthy. The shares pay a dividend yield of 3.0% and has recently seen significant insider buying. There are certainly arguments against investment in the financials, but there is also significant upside potential for long-term investors.

While Banco Santander has some good exposure to the emerging markets, which are still relatively healthy, they have been selling assets lately to meet new liquidity rules. This could detract from future earnings and the bank will eventually need to go back into the markets to buy back into emerging market growth. The bank is also on Standard & Poor’s hit list as possible downgrades in a note reported last Thursday.

This type of hedging strategy is more dynamic than my general portfolio strategy. If the euro were to rally 10% to $1.45 with little conviction for a real debt solution, I would probably increase my bet against the currency. Similarly, if the currency were to weaken by about 10% to $1.20 I would probably sell out of some of the hedge and use the profits to offset losses in the rest of my portfolio. Though further losses could occur beyond $1.20, there seems to be pretty strong support at that level and I would want to bank my 10% gain given the scenario.

Disclosure: I am long XLF and short FXE and IPF