The concept of a “hedge fund,” as they were traditionally known, was that these funds would be long a number of stocks in a portfolio, but would hedge that long position with various short positions. Those shorts would act as a hedge because they might be some form of an index to offset a long position in various individual equities, or vice-versa.
In some cases, the long positions of individual equities might have a hedge in the form of other equities that would suffer if their counterparts did well.
The combinations remain endless, especially now with exchange-traded funds that can make it easier to hedge just about anything. Some ETFs are themselves hedge funds of a kind.
You can construct a hedge yourself, especially in a time where the overall markets are insanely overpriced. A market price-earnings ratio of 25 is well above the long-term average of 16, so if you want some peace of mind, consider a portfolio hedge.
How to Hedge Your Portfolio: IQ Hedge MultiIQ Hedge Multi-Strategy Tracker ETF (QAI)
Speaking of an actual hedge fund approach, look at IQ Hedge MultiIQ Hedge Multi-Strategy Tracker ETF (NYSEARCA:QAI). I wouldn’t use this to hedge against your entire portfolio, but rather as a way to diversify your investments to include a portfolio hedge strategy within it.
So what exactly is the QAI? It tries to create a hedge fund mirror, by going after risk-adjusted returns that hedge funds use. That could include both long and short equity positions, and specialized approaches like “global macro,” market neutral positions, holding stocks that are event-driven, using arbitrage with fixed income securities and investing in emerging markets.
Its holdings will change from time to time, and right now, it’s actually behaving a lot like a diversified bond fund: 26% is invested in investment grade corporate bonds, 21% in a short term bond index, about 27% in various other bonds and Treasuries, about 4% in a short position in Treasuries of short duration to offset it all, and 9% in other short positions.
How to Hedge Your Portfolio: ProShares Short S&P 500 (SH)
Of course, if you want to strip down to basics, you can just take a short position against the S&P 500 Index. The ProShares Short S&P500 (ETF) (NYSEARCA:SH) is the obvious play here. This is great for someone like me.
I happen to hold a lot of small and mid-cap value stocks, which are hopefully not as vulnerable to a correction based on valuation. If I create a portfolio hedge by holding the entire S&P 500 short, via SH, then I may protect some of the possible downside in many of my holdings, and possibly profit if the larger stocks melt down.
It’s certainly possible. Earnings are supposed to grow at around 20% going forward, and that’s not going to happen. So the P/E ratio of 25 is not going to hold up, if you ask me.
How to Hedge Your Portfolio: ProShares UltraShort S&P 500 (SDS)
If you happen to think the market is heading for a big fall, or if you want to double your hedge, you can use a leveraged short ETF. ProShares UltraShort S&P500 (ETF) (NYSEARCA:SDS) gives you twice the short exposure.
Many investors think that gold can act as a good hedge. I don’t disagree. Hard assets are where people run to when times are bad. Even though gold has its ups and downs, and I don’t like it as a long-term play, it can work very nicely as a hedge.
In addition to be a precious metal, that is troublesome to mine, is heavy, and cumbersome when it comes to storing it, gold also has practical use in various industries.
It’s not as expensive and it actually holds both physical gold and silver in its vaults at a 2:1 ratio. That also gives you diversification in precious metals in case gold doesn’t climb as much as silver does, or vice versa.
Lawrence Meyers is the CEO of PDL Capital, and manager of the forthcoming Liberty Portfolio stock newsletter. As of this writing, he has no position in any stock mentioned. He has 22 years’ experience in the stock market, and has written more than 1,600 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.