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Hedging Strategies – Using A Systematic Approach To Protect A Portfolio Against Another 2008 Style Decline

|Includes:QQQ, SPY, iShares 20+ Year Treasury Bond ETF (TLT)

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Hedging strategies are becoming more popular as investors worry that another 2008-type decline is around the corner.

Hedging Strategies - Using A Systematic Approach To Protect A Portfolio Against Another 2008 Style Decline

Lately I have been reading more and more articles in the financial press about how another major stock market decline is at our doorstep.

The problem is how to decide when and if another major stock market decline will occur and how to protect your portfolio without missing any potential market upside.

Typically, I like to use inverse ETFs in a portfolio during a long term decline in order to capture performance on the decline.

However, not all investors understand or are comfortable with inverse ETFs. So I put together a more systematic approach that can be added to any portfolio and easily implemented.

What Are Hedging Strategies?

First off, what is "hedging" and why should you be interested in using it?

I like to describe hedging a portfolio as buying insurance for a portfolio in case of a major decline. In the past, hedging strategies were something that were employed by hedge funds. Hedge funds would sell stocks short to create long/short strategies.

Today, these long/short strategies can be created using various investment vehicles such as options, commodities and inverse ETFs.

The concept is that you are trying to reduce the impact in your portfolio in case of a large market decline - much like car insurance would reduce some of the financial impact of a major accident.

Nowadays, the concept of hedging has been expanded from the traditional definition of a long/short strategy to that of any active strategy that can protect a growth portfolio during a market decline.

Investors have become more interested in various hedging strategies since the 2008 market decline. During 2008, the typical diversified portfolio was severely impacted as all equity asset classes incurred declines:

Example of a diversified portfolio in 2008.

A Systematic Approach To Hedging A Portfolio

I want to present an ETF-based hedging strategy that is easy to implement and can be added to a percentage of your portfolio based on how much risk you want to take in your overall financial plan.

The strategy is designed to enhance portfolio returns during a rising market by investing in the strongest market sectors, but then to systematically move into iShares 20+ Year Treasury Bonds ETF (TLT) as markets begin to decline.

While this does not fit the mold of "traditional" hedging strategies, it is one that can be used by investors who are not comfortable with short selling, options or inverse ETF strategies.

This also assumes the next market decline will be a beta collapse, similar to what happened in 2008.

The ETF universe that I am using is comprised of the major S&P 500 index sectors:

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To start, this strategy focuses on the relative strength of the above ETFs vs the S&P 500 index.

The below charts are from Select Sector SPDRs relative strength research. Specifically, they show the 52 week relative strength vs the S&P 500 index as well as the 39 week moving average.

I have found that this overview provides a great way to see which sectors are outperforming the overall markets. This is then used to overweight the strongest sectors in a portfolio.

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Confused Yet?

I am sure you are now scratching your head, saying "John, I thought you said this was an easy strategy to implement."

Fortunately it is.

Using a site like ETFreplay.com, you can create and track this strategy. (Note: I am not affiliated or endorsed by ETFreplay. It's just a tool I use and wanted to share.)

5 Steps To Hedge Your Portfolio

1) Allocate a portion of your portfolio to this strategy based on risk tolerances.

2) Buy the top three strongest ETFs (from above list) based on relative strength.

3) Check the relative strength at the start of each month, make any revisions when necessary.

4) At the start of each month, compare the relative strength of the top 3 to iShares 20+ Year Treasury Bond (NYSEARCA:TLT).

5) If "TLT" has a stronger relative strength signal, then the sector ETF is replaced with "TLT".

Note: "TLT" will replace all ETFs that have a weaker relative strength.

For example: If you choose to buy the top 3 ETFS and "TLT" is ranked 2nd, then you will invest 25% in the top ETF and the remaining 75% in cash.

If you choose to buy the top 3 and "TLT" is ranked 3rd, then you will invest 50% in the top 2 ETFs and the remaining 50% in cash.

Performance

So, how does this strategy perform?

In rising markets, the positive relative strength of the top 3 ETFs will enhance portfolio returns most years.

In years such as 2008, hedging strategies like this can help protect your portfolio by systematically moving a portion into the iShares 20+ Year Treasury Bond (TLT) ETF.

As markets begin to rise again, the relative strength signals will indicate when and which sectors are beginning to outperform the S&P 500 index.

This systematic approach will help you ignore the "noise" of the various financial outlets and allow you to remove "evening news opinion investing" from your portfolio.

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For a detailed trade by trade overview: Hedging Strategies - Using A Systematic Approach To Protect A Portfolio Against Another 2008 Style Decline (PDF).

Disclaimer: These are not actual portfolio returns, but a backtest of this strategy. Past Performance Does Not Guarantee Future Results. This is not a recommendation and you should consult a financial professional to see if this or other hedging strategies fit into your individual portfolio. Please read the full disclosure page here.

Performance During 2008

A reoccurring question on hedging strategies that pops up is "How did it perform in 2008?". 2008 was what I would classify as a "beta collapse", meaning all equity asset classes collapsed, as opposed to the tech bubble collapse of 2001-2002, where assets flowed out of the technology sector and into value stocks.

Today, many are worried that the current high portfolio margin level combined with a still struggling global economy, portends a similar decline to 2008 - encompassing all equity classes.

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source: dshort

This fear is why I wanted to emphasize a simple, ETF-based hedging strategy that could systematically move a portion of one's portfolio into an ETF that tracks US Treasuries ("TLT").

For those who are curious, this is a more detailed view of 2008:

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How Are You Planning To Hedge Against The Next Decline?

I would love to hear your thoughts on various hedging strategies - both simple and complex. Feel free to leave a comment below or you can reach out to me privately here.

- John

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Stocks: TLT, SPY, QQQ