Hedging your portfolio is a strategy that is often employed by those who want to take out some downside protection against the possibility of a market drop.
The most successful application of this process is to reduce your exposure in highly appreciated long positions with the assets that demonstrate inverse or non-correlated properties to the broad equity market.
This will allow you the flexibility of reducing your risk profile without having to shift your holdings to cash or disturb your existing cost basis in a taxable account.
Playing defense in the midst of a correction or even a bear market may help you sleep better at night knowing that your capital has some layer of protection from a measured move lower.
Exchange-traded funds make for a very easy way to access this type of strategy because they provide instant, transparent and low-cost access to a variety of asset classes. You can shape your hedge to reduce stock market risk, interest rate risk, commodity risk or any combination of those major groups depending on your needs.
For instance, the ProShares Short S&P 500 ETF (SH) is a popular way to play an inverse relationship with the S&P 500 Index. SH is designed to move inverse (or short) the same percentage move as the S&P 500 on a daily basis.
According to ETF.com, this fund has seen net inflows of $728 million from the beginning of the year through Feb. 9. This should come as no surprise given the strong downdraft in the market and rush for protection that many investors are trying to capitalize on.
Another popular strategy for hedging your stock market risk is to own long-duration Treasury bonds such as the iShares Barclays 20+ Year Treasury Bond ETF (TLT).
This fund owns a concentrated basket of Treasuries with maturity dates greater than 20 years. The end result is a single vehicle that is highly sensitive to changes in interest rates. TLT won’t provide a perfect inverse relationship to the stock market, but there has been a historically high correlation of falling stocks coinciding with a rush to safety in Treasury bonds.
When fear of losses in paper assets set in, there is often a concomitant rush to own precious metals such as the SPDR Gold Shares ETF (GLD). This exchange-traded fund tracks the daily price movement of gold bullion and has been steadily climbing higher in 2016.
Many investors have become disenfranchised with the multi-year downtrend in gold prices. However, the recent surge in the yellow metal, alongside swelling volume, is a possible sign that those misfortunes are due to change.
Similar to TLT, gold bullion will not offer a perfect inverse correlation with the stock market and should be evaluated on its own technical and fundamental merits as an effective hedge for your specific portfolio.
It should be noted that adding exposure to non-correlated investments opens you up to the risk that the market once again resumes its climb and these hedges fall quickly in value.
That is why it is imperative to have a nimble trading strategy when considering these investments for your situation. Timing and risk management are important considerations to avoid getting caught chasing the tail end of a market cycle as a result of short-term performance concerns. Position sizes of any hedge should be small enough to deflect any real damage to your core portfolio.
Investors that are considering adding a hedge to their portfolio should first ask themselves the following questions:
- What is the most appropriate vehicle to accomplish my goals?
- What is the maximum capital at risk in the event that the hedge is unsuccessful?
- What alternatives are available that may offer a varying approach? i.e. options, cash, sector rotation, etc.
The comfortability of trading in ETFs has led many to seek out highly leveraged funds, volatility futures and other aggressive strategies that significantly magnify the risk equation.
I have purposefully left these possibilities out of this discussion because I believe they lead to far more harm than good for all but the most disciplined and short-term traders.
For many investors, simply not taking an undo amount of risk to begin with is a far more satisfying method of risk management than trying to time every dip in the market.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. To get more investor insights from FMD Capital, visit their blog. Click here to download their latest special report, The Strategic Approach to Income Investing. Learn More: Why I love ETFs, And You Should Too
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