Build Your Own Global ETF Hedge Portfolio

Includes: EWD, EWZ
by: Carl T. Delfeld

With more than 10,000 hedge funds on market holding $1.5 trillion in assets, if you don’t have any money in a hedge fund you may wondering if you are missing out of the big game. The Yale University endowment (for example) is 25% invested in hedge funds seeking absolute returns.

But with the emergence of exchange-traded funds or ETFs, you have at your fingertips the ability build a global ETF hedge portfolio that is the envy of your friends - and you won’t have to give away 20% of your gains to a hedge fund manager.

What is a Hedge Fund?

Before we get into how to build your ETF hedge portfolio, let’s look at the history of hedge funds and how they have evolved. Hedging means to reduce risk while speculation is seeking more return by taking on more risk. A hedge fund is a private investment partnership that invests with goal of more return than risk for each dollar invested. The first hedge fund was started by a former Fortune magazine columnist Alfred Winslow Jones in 1949 and he also set the standard for fees which continues to this day: a fee equal to 2% of assets and a performance fee of 20% of gains.

There are an infinite variety of hedge funds but they can be broken down into two categories. Non-directional funds seek absolute returns by using a long/short approach and tend to generate steady but unspectacular returns. Directional funds allocate assets using only limited hedging. Both seek alpha – return over a benchmark from the investment process, skill of the fund manager or let’s face it, just plain luck.

Mediocre Hedge Performance

How are hedge funds doing? In 2005, according to CS Tremont index, average global macro fund returned 7.6% versus 10% for MSCI EAFE index (NYSEARCA:EFA) - and in 2006, 13.5% compared to 18% for the MSCI World index. According to study by Henry Kat of the London Business School, only 17.7% of hedge funds provided investors with returns they could not have generated themselves. Why?

Most attempt to exploit anomalies within markets and asset classes rather than between markets and asset classes. Many hedge funds try to do too much and look at too many markets but still lack global diversification. The result? Hedge funds have become commodities competing for opportunities in the same markets.

ETF Advantages

You can build a diversified global ETF hedge portfolio by tactically allocating ETFs with the goal of exploiting anomalies between global markets rather than in markets. The tools are certainly there with over 400 ETFs now at your fingertips from 20 different country ETFs, U.S. sectors and sub-sectors, international sectors, global sectors, commodities, precious metals, currencies, regional, inverse ETFs, different asset classes and growth/value choices.

Investors now also have a choice regarding how companies are selected and weighted in the ETF baskets. Company weighting in the ETF basket is done on the basis of market value, revenue, fundamentals, technical factors, cash dividend record are just some of the choices.

Besides the variety, there are other reasons to go with ETFs such as tax efficiency, flexibility, transparency, and the increasing availability risk management tools such as inverse ETFs, put options, stop losses and the ability to sell short.

Despite these ETF advantages, you will still need a disciplined process with clear action triggers and risk management tools to lock in gains, minimize the impact of mistakes and a comfort level with periodic high cash levels.

Cash, Liquidity and Income Come First

You also have to think through how this portfolio fits into your overall investment plan. Put in place plenty of liquidity through cash or money market funds. You also need a strong comfort level regarding income to meet your current and long-term needs. A good advisor can run a model for you so that, even in the worst case scenario, you will be safe and secure. With this security plan in place, you can then look confidently and at more creative and higher potential for growth portfolios such as a global ETF hedge portfolio.

Set Global Asset Allocations

But what should be the investment process for selecting and removing ETFs from your global hedge portfolio? Here is how we approach it.

Before jumping ahead to select a basket of ETFs, we first use a top down approach by allocating assets among different equity markets such as the U.S., Europe, Asia-Pacific and emerging markets as well as some foreign currencies.

Then we set a target allocation for fixed income and inverse ETFs which move opposite of markets and serve as a hedge or portfolio buffer for down markets. Next, we address real assets by making allocations for precious metals, real estate, timber, oil and other commodities.

The Yale Model

This is close to how large endowments are managed at universities across America. For example, below is the asset allocation for Yale University which was described in a recent New York Times article. Yale’s endowment has grown at an annual compound rate of 16% from $1.3 billion in 1986 to $14 billion in 2006.

the yale model

At this stage in the cycle and accepting that most investors will have less access to hedge funds and private equity, my preference would be to allocate more to U.S. and foreign equities and to have a larger cash position than the Yale model.

A Process to Filling Your Allocations

The next step is to fill your allocations with appropriate ETFs. Here is the selection process we use that might serve as a model.

First, you need to look at the fundamentals of the top 5-10 companies in the ETF you are considering. These include the composite price to book, p/e ratio relative to other companies and countries. We call this the ETF XRAY.

Next, consider price momentum looking at 50 and 200 day moving averages. Then consider where top global managers are putting their cash to work and where in the world net cash inflows and country and sector allocations are increasing.

You also need to look at the big picture macro economic factors such as interest rates, currency, fiscal discipline and economic growth rates. The direction and pace of these
variables is more important than where they sit right now. Political developments and events such as elections and market economic reforms are also crucial.

Finally, consider technical factors such as point & figure charting as a final check as to timing and to determine where your support levels might be.

Putting in Place a Risk Management System

To manage risk and determine when to sell a position, use a clear and disciplined process.

Have a maximum 10% position in any one ETF with a 5% cap for emerging markets.

Sell an ETF position if it falls below 200 day moving average or if it falls 8% below its trailing high. Purchase put options on ETFs when available and appropriate. Use modest levels of inverse, sector, precious metal, currency ETFs to buffer your overall portfolio. Rebalance annually to take some gains off the table.

Finally, use the discipline of limiting your portfolio to no more than twenty ETFs. Fifteen ETFs is probably a pretty good number with five 10% positions and ten 5% positions. This avoids the problem of having too many positions in your portfolio since this dilutes the contribution of your best performing ETFs. Having a limit also forces you to sell an ETF before adding an ETF.

Case Study: Brazil

How does this whole process work? Here are two examples for the Brazil (NYSEARCA:EWZ) and Sweden (NYSEARCA:EWD) ETFs during 2006.

For Brazil in early 2006 the international fund flows were positive with global equity managers moving to overweight positions and nice net cash inflows. The macro fundamentals were also positive with 3% inflation, foreign exchange reserves $100 billion, $46 billion trade surplus and interest rates high but beginning to fall. The Brazilian companies in the ETF were trading at just over 10 times earnings and the technical chart was also promising. The re-election of President Lula and continued market reforms was anticipated with a fair amount of confidence. The Brazil ETF was up 45.4% in 2006

Case Study: Sweden

In the case of Sweden, the international fund flows were positive and the macro. Fundamentals impressive: strong fiscal discipline, inflation 2%, interest rates slowly rising leading to an appreciating currency. The top ten ETF holdings led by Ericsson (21%) showed nice balance split between capital, technology and banking. The relative valuation of these holdings was only 12 times earnings.

Technical factors were positive with EWD showing solid price momentum. Politically, in the upcoming election, the center-right coalition led by Mr. Reinfeldt based on platform of tax cuts and privatization appeared to have an excellent chance at victory. The Sweden iShare was up 25% during 2006 and is still going strong.

You can see that ETFs as a core investment tool give individual investors the opportunity to build first-class global portfolios that until recently were the purview of only the largest and most sophisticated institutional investors. For example, there is a team of 100 money managers that oversea the Yale University endowment and a sizable staff that oversees the investment process.