The term "Risk Management" was a foreign concept to me in late 2007. After five years in the market and a slew of random stock picks I had an awkward collection of stocks with no cohesive investing theme or direction. A whole lot of Citibank (NYSE:C) and some marginal stocks like Brocade (NASDAQ:BRCD) and Sirius (NASDAQ:SIRI) adorned my portfolio for no particular reason except that they were the stocks that were most talked about at some point in the last five years. And then the crash came and when I came out of it at the other end I had a healthy dose of respect for what it meant to have a balanced and diversified portfolio with a specific investment thesis, however misguided it might be. By 2011 I had cleaned up a lot of my random picks and had a tight portfolio with a central theme behind it. But as 2014 rolled in I started getting nervous about the gains that had been racked up in my portfolio and the S&P 500 chart was looking ominous with a gradient that would put any black diamond slope to shame. But with my investment thesis in place and a portfolio to match it I did not want to get out of my holdings and fancied buying at lower levels. This is when the amateur investor in me looked to grow up and introduce the concept of hedging in my portfolio. Though I admit I was a little too early in this process and the market has stuck its tongue out at me for the past 12 months, I am convinced that the hedge is necessary as I hold my portfolio steady for the wild ride.
Lets start with why I think I need to hedge my portfolio:
- The uninterrupted climb in S&P is unprecedented and needs a correction at some point.
- An impending rise in interest rates by the Federal Reserve will cause a correction in the equity market, albeit for a short time before the market resumes its upward momentum until such time that the economy starts experiencing a real recession.
- The real rate risk at the long end is not the interest rate hike but the sale of long term bonds that the Federal Reserve is holding on its balance sheet.
- A recovery of oil prices to more normal levels will have an inflationary effect.
- The rise in cost of borrowing is going to impede some of the buyback largesse that has been witnessed in the market over the last few years and would impact specific S&P sectors that I am invested in.
- The steady increase in treasury yields in last three weeks and the sudden pop in German Bunds is a sign of stress in some part of the sovereign debt market. (Somebody wants their money back in a hurry for something.)
- The real benefit of a correction is a better entry point and the hedge allows you to reduce the downside of the correction.
- Every balanced portfolio should looks to hedge specific risks. It also makes the exercise of investing a lot more interesting.
Now lets look at the possible hedges given the catalysts that I have listed above.
The first hedge is against rising interest rates. Though the rising rates are not a direct threat to my portfolio necessarily, it is something that I perceive as an investable event for the next couple of years. The Federal Reserve will raise short-term interest rates progressively in the next two years or so. If history is any indicator, this may not necessarily affect the long-term rates as evidenced by Alan Greenspan's "conundrum." But the real event in interest rates would be when the Feds start unwinding the long-term bond purchases that they did in the last leg of quantitative easing. These two events together make "shorting" the long-term treasuries a good bet. The ProShares Short 20+ Year Treasury ETF (NYSEARCA:TBF) is my instrument of choice as this is an ETF that tracks the Barclay's US 20+ year Treasury Bond index with a 1x negative correlation. This instrument allows me to hedge the market events that will follow the rise in interest rates and though it does not specifically protect my equity exposure it protects one of the correlations in the market which is a downward pressure on equities (initially) on rising interest rates. TBF is preferred for its liquidity in terms of market volume and its high correlation to the yield curve. The Direxion Daily 20+ Year Treasury Bear 1x ETF (NYSEARCA:TYBS) offering is a cheaper alternative (in terms of expense ratio) but suffers from a chronic problem of fund size and liquidity.
The second hedge is a direct hedge for my long exposure to the market that I have no plans to reduce. This would be to "short" S&P. While the ProShares Short S&P 500 ETF (NYSEARCA:SH) would be a good alternative, it does not provide the necessary leverage that I seek as a hedge. The Ultra Short ETFs (that provide the additional leverage) suffer from two distinct disadvantages of high expense ratio and a poor correlation to the index that is seeks to short. This is a big handicap especially if you are not sure of the exact timing of when the market would turn and will decay the capital you invest into that hedge. I prefer to pick a put option that is three to six months out as a fair balance of cost-to-protection. I would also pick a put option that is significantly in the money at this point because my thesis on the market states that a significant leg up for the market will not come without a correction at this point. Additionally, put options significantly in the money tends to have a low premium and so the extent of the market correction doesn't have to be too severe to start getting the required protection. As an example, I am invested in a 220-strike option that expires on September 30th at a cost of $13.25.
The third hedge would be the Financial Select Sector SPDR ETF (NYSEARCA:XLF) as a hedge against rising interest rates and increased volatility that comes with it. With rising interest rates the large money center banks would have better margins on the lending business and the increase in volatility would greatly assist their trading desks. Both these are positives for the financial sector that has been stuck in a funky state for the past 12-24 months waiting for the catalyst to propel their business out of the rut they have been since coming out of the financial crisis. With better capital reserves and improving business conditions the banks would also be capable of returning capital to shareholders over the next few years. The reason to pick an ETF as opposed to a specific stock is a hard lesson learned in the financial crisis, which is to not trust any one bank with your money, be it, your savings account or your investments.
The time is now to put in these hedges. The rhetoric in the market is clearly picking up and the long positions in the market are looking ever more vulnerable.
Disclosure: The author is long XLF, SPY.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This is a record of my investment ideas not intended as investment advice for anyone.