Decrease Your Investment Risk Using Natural Hedging

| About: Energy Select (XLE)
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I am starting to write a series of articles on relatively easy ways almost every investor can increase their long-term investment returns and decrease risks and volatility.

Today, in the first article of this series, I would like to focus on what I call natural hedging.

By natural hedging I mean investments, which essentially hedge our real-life investment positions, exposures or expenses. By real-life investments I mean the actions that we have to or want to undertake in our lives anyway, regardless of whether we are investors or not at all.

For example most of us have expenses related to costs of living such as housing, whether in form of a mortgage, or rent, or an opportunity cost of living in our house that has been fully paid down and in which we have tied certain capital. Other examples are our utilities costs like electricity, gas, water and waste, internet, phone, etc. We have more expenses in the form of food costs, whether in form of groceries or restaurant bills. Other costs include driving costs in form of car ownership or renting or public transportation costs, gasoline and other car-related costs.

All these costs and investments expose us involuntarily to risks of rising prices of these services in the future, if we plan to continue undertaking these expenses.

How can we protect ourselves from this risk of future rising costs? One relatively easy way is by investing in instruments that actually benefit from the rising of these specific costs. Such positions, if sufficiently correlated with the costs which we intend to hedge, will be profitable when our costs of living rise. This profit will partially or fully offset the loss that we incur by having to spend more in the future for our living. Every coin has two sides and in this case the caveat is that if the future costs of living fall, you actually will not benefit from this drop, because you will have a loss in the hedging position, which will suffer from lower costs of future living. However, if you are convinced that the future costs of living are likely to rise in the long-term as I am, or are afraid of such a case, you should definitely hedge at least partially your future expenses as part of your overall investment strategy. Additional benefit of this natural hedging is that the actual net amount of your future expenses will become more stable, more predictable and easier to plan for.

Let's take as an example the costs of gasoline and your energy costs in general. There are multiple ways you can hedge these types of rising costs:

1. Invest in oil futures directly. This might not be a feasible strategy for a large investor base due to more complexity and risk associated with futures trading. Futures trading also usually requires different a trading account allowance by your broker.

2. You can also invest in futures-based oil Exchange traded funds (ETFs), such as DB Oil Fund (NYSEARCA:DBO) or United States Oil Fund (NYSEARCA:USO), which are accessible to virtually all investors. United States Gasoline Fund LP (NYSEARCA:UGA) tracks not the price of oil but directly the price of gasoline.

3. The third way is to invest in products based on actual stocks that are related to oil. A good example of such investments are ETFs Energy Select Sector SPDR (NYSEARCA:XLE), internationally diversified S&P Global Energy Index Fund (NYSEARCA:IXC) or SPDR S&P Oil & Gas Exploration & Production (NYSEARCA:XOP) and ETF based on MSCI US Investable Market Energy 25/50 Index (NYSEARCA:VDE).

4. You can also invest directly in individual oil-related stocks such as Exxon Mobil Corporation (NYSE:XOM), Chevron Corporation (NYSE:CVX), British Petroleum (NYSE:BP) and ConocoPhillips (NYSE:COP), one of Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) stock holdings.

Let's have a look at a 5-year cumulative performance of WTI Crude Oil versus oil and energy-related ETFs and stocks:

5 year cumulative return in %
WTI OIL -15.32
DBO -34.86
USO -61.46
UGA +22.7
XLE +11.87
IXC +0.47
XOP +17.9
VDE +12.18
XOM +3.1
CVX +40.1
BP -35.79
COP -24.3

Source: Oil spot price 5-year performance calculated from the data from the US Energy Information Administration). ETF data based on data. Stock price data based on Google finance data.

As you can see from the table above, the oil futures-based ETFs substantially underperform the WTI Crude Oil price movement in the long term. This is predominantly caused by the futures contango. ETFs based on actual oil stocks fare much better and are able to outperform the price change of oil and also fare relatively well compared to the Dow Jones Industrial index 5-year performance of 24.05%. Nonetheless, they lag the benchmark index.

My recommendation is to hedge part of your future energy costs by including a combination of UGA and XLE ETFs in your portfolio to hedge future rising costs of energy and gasoline and offset some of the ups and downs of your monthly energy costs. If you want to buy individual oil stocks, I recommend buying a broader portfolio. 4 stocks at the minimum, such as all of the ones mentioned in this analysis, XOM, CVX, BP and COP, due to the fact that individual stocks are more volatile than broader sector indexes and their performance is in a major way influenced by the individual development of these companies. Therefore you would need to purchase and monitor more titles to achieve relatively smooth performance from year to year.

As to other costs of living, such as food and housing costs, you can similarly find suitable ETFs and other investment vehicles to hedge the potential rising costs. In food, I recommend looking at the broad agriculture ETFs DB Agriculture Fund (NYSEARCA:DBA) and DJ-UBS Agriculture Subindex Total Return ETN (NYSEARCA:JJA).

For housing costs, if you are paying down a mortgage, I suggest to be protected from the rising interest rates by - well - paying down your mortgage and other debts faster - that is make an extra payment of as much as possible if you have the option, while keeping some emergency cash of course. Also, refinance your mortgage to lower interest rate. You can also trim down your long duration bond investments as they will generally lose value in a rising interest rates environment. And finally, you can buy inverse long duration US Treasury ETFs, such as Short 20+ Year Treasury (NYSEARCA:TBF) and Daily 20 Year Plus Treasury Bear 1x Shares (NYSEARCA:TYBS).

As always before making any investment, make sure you do your due diligence and research the individual tickers details to make sure such investment fits within your personal investor profile and overall strategy and needs.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in XLE, UGA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.