Yesterday, I got an email from a Seeking Alpha member who wanted to know the best way to hedge his long equity exposure. Hedging is a very tricky subject because hedging isn't free.
If you get the timing wrong, it's an alpha killer. If you get the vehicle wrong, it may not work at all. And if you pay too much in fees, you can wipe out some or all of the advantages of hedging.
In this article, I will limit the discussion of hedging vehicles to ETFs that have been around for at least one year. Ideally you would want to choose one that has been around long enough to have demonstrated its effectiveness during a significant market decline. But there aren't any that I know of that were around for the last bear market in 2008. So we have to go with the data at hand.
Hedging ETFs come in several flavors, so the first decision to make is what you want your hedge to do. If you want a "pure" hedge, then go with an inverse ETF. The problem with this is that inverse ETFs are a rapidly wasting asset. If you're too early, you will lose. I tell clients to avoid inverse ETFs unless they are willing to hold them for no longer than two weeks.
Then, there are "market neutral," "long/short" and "real return" ETFs that have the shared goal of capturing at least some upside while limiting or eliminating any downside. The problem here is that most of them don't deliver on that promise. It turns out that this is a very hard thing to pull off, especially when you consider the high expense ratios involved.
Managed Futures ETFs are interesting. The key selling point, in my opinion, is their negative correlation to stocks. The disadvantage is that as long as the bull market remains intact, these ETFs will suck alpha from your account.
So what's a worried investor to do? I can't make a blanket recommendation because I don't know your circumstances. But I can tell you what I say to my clients who want some protection. If you're that worried about a big market decline, then cut back on your equity exposure. It's cheaper and more effective than hedging with an ETF.
But there is a valuable use for these vehicles. Allocating 5% or 10% of your portfolio to an ETF that is negatively correlated to equities will improve your Sharpe Ratio, reduce the volatility in your portfolio, and maybe even help you sleep better at night.
Just don't expect too much in the way of capturing additional alpha.
Here is a table showing the 27 hedging ETFs that I track. More are being added every month, but I only look at the ones that have been around for at least a year.
I recently launched a Seeking Alpha version of a stock-screening algorithm that I've been using with clients since 2005. It has an excellent track record, and you might find it attractive for a portion of your investable funds.
If you're interested in finding out how it works, send me a message and I'll send you the details.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in RALS CHEP QAI CSLS QMN FMF MRGR WDTI BTAL 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.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.