The Key to Portfolio Management: Hedging Your Investments

I’m not at all convinced that market volatility will somehow remain at the historic low levels that currently paint the investing landscape. No way — not with all the high-frequency trading being heavily influenced by a sharp rise in the use of futures, options and widespread application of margin by funds.

Now is a good time to start thinking about some simple portfolio management strategies. If you’re invested in the market, you’ll want to protect your investments following a major run-up, when market risk is inherently higher.

The explosion of exchange-traded funds, or ETFs, has made it possible to custom-tailor almost any investment theme by investing in managed baskets of stocks targeted at specific sectors or indices. You can buy everything from commodities, currencies, real estate, bonds and almost every kind of index in the form of publicly traded ETFs.

I like using ETFs that are linked to the stock market as a counter lever to holdings in my model portfolio. After weeks of intense buying, the market enjoyed a huge 9.5% pop off the October low and now runs the risk of some form of post-New Year correction going into the next budget battle and debt-ceiling deadline set for Jan. 31.

Congress looks like it’s moving toward a deal, but any bumps along the way could very likely trigger a reason to sell as we sit and wait for an all-clear sign from Capitol Hill. I hope I’m wrong, but there is a well-worn, proven pattern to how Congress operates in the war of wills and pending deadlines. It’s for this reason that I want to introduce portfolio management hedging techniques that I expect to act upon soon when the time is right.

The fortunes of the high-income stocks I recommend are closely tied to the broader performance of the stock market, so my focus for protecting capital will be on using ultra-short ETFs on the S&P 500 and the Nasdaq. Here is a sample list of ETFs that could be used to hedge a fully invested portfolio of long positions:

  • ProShares UltraShort Dow30 (DXD)
  • ProShares UltraShort S&P 500 (SDS)
  • ProShares UltraShort QQQ (QID)
  • ProShares UltraShort Russell 2000 (TWM)

The list above is just a smattering of what’s in the universe of ETFs but among the most liquid and widely used protective ETFs are the PowerShares UltraShort S&P 500 (SDS) and the PowerShares UltraShort QQQ (QID). An ultra-short index ETF represents a two-for-one form of downside leverage against a falling market.

For example, if the S&P 500 drops 1%, the value of the ultra-short S&P 500 ETF share increases by 2%. The same holds true for the QID, which is tied to the Nasdaq. For every 1% the ProShares QQQ Trust (QQQ) falls, shares of the QID will increase in value by 2%. For a portfolio hedge, this is about as simple as it can get.

From a historical standpoint, the kind of move off the bottom that the market has enjoyed and looks to continue through the first week of January is usually followed by a 50% retracement of that sensational rally. Before this rally phase is complete, the S&P 500 could gain 15%-20% from its October low. Giving back half that move in a sudden pullback would not be out of the question and would actually be constructive, but at the same time would feel very painful coming in at these levels or higher.

If we are going to be entering a period of Fed tapering in which wide swings in major market indexes, interest rates, commodity prices, day rates and currency relationships become daily events, then I want to add some useful portfolio management tools that can have an immediate impact on mitigating future risk when the signs of a short-term market top start to materialize. The wind is still to the back of the bulls, but it’s best to hedge into strength.

Plus, when the market is being driven by extreme levels of greed and performance pressure, it helps a great deal to use that manic bullishness to pay as little as possible for portfolio insurance.

It is my contention that the market may price in a good dose of future good news right after the initial flood of fresh funds flow into the market the first week of January, when rising expectations of fourth-quarter earnings will be building into the reporting period. I think it best to begin planning portfolio management tactics to mitigate the potential value gyrations in our holdings if there is no meaningful progress on the debt ceiling during the next three weeks.

It’s easy to be bullish and hard to be cautious, but downside risk remains until there is a clear deal on government spending and risk surrounding any notion of default is eliminated from what will surely be another round of hotly contested budget debate. Portfolio management in the form of inverse ETFs can go a long way in protecting your investments.

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Bryan Perry is the editor of Cash Machine, a newsletter focused on high-yield income investing with the goal of maintaining a blended total yield of 10% across two portfolios. Bryan is also the editor of Extreme Income,which uses the power of historically cheap money to create a leveraged “baby hedge fund” strategy that paves the way to massive profits and 4x greater income.

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