The (Almost) Perfect Hedge

With the overall market being less than impressive the last couple of months, a lot of readers have been asking about ways to defend against broad market weakness. Well, we could write a book on how to play defense with your portfolio (although it wouldn't be the first book on the topic). Some of the initial ideas that come to mind are the obvious ones…set tight stops, sell short, buy puts, etc. All of them are great ideas, and we may even detail those strategies in a later blog entry. For today however, we just want to throw out a hedging idea you may not be quite as familiar with.

We're going to make one basic assumption here - any reader who's interested in our serious small cap ideas also probably has a brokerage account in which they can actually trade stocks. If you have that ability, you almost certainly have trading access to a number of mutual funds.

We're looking for one kind of fund in particular…an inverse and leveraged fund. The most notable fund company with such a fund is Rydex - they actually have several of these funds. ProFunds offers them too, although their options aren't quite as numerous as with Rydex. (And no, this isn't an endorsement of either of the companies…they're just convenient examples.)

If you're not familiar with the concept of a leveraged fund, it's actually easy to grasp. A leveraged fund is an index fund designed to move with the index, but by a greater degree. In most cases, the degree of leveraged movement is 2 to 1. Or in other words, for every percentage point the S&P 500 gains, the 2:1 leveraged fund gains 2 percentage points. Of course, if the SPX falls by 2 percent, the leveraged fund falls by 4 percent. See the potential as well as the risk?

Enter inverse funds. An 'inverted' fund moves in the opposite direction of an index. For every percentage point the S&P 500 loses, an inverted fund will gain a percentage point. Adding in the leverage, this fund would gain 2 percentage points for every percentage point the SPX lost. Again, do you see the potential, as well as the risk?

OK, so where does the hedge against a bearish market come in? Let's take a look at a realistic example. Let's just say your current portfolio is 2/3 invested in long positions, and 1/3 of the portfolio is held as cash. Assuming your stocks 'mirror' the market on a day-to-day basis (which 75% of stocks do), if the market is sinking, odds are your portfolio is sinking by about 2/3 of that rate. While it's great to see your losses aren't as big as the market's losses, (1) that's only the case because your potential gains are also limited to 2/3 of the market's gains, and (2) you're still losing ground.

So, if the market sinks by 6%, your account only sinks by 4%. Check out the math on a hypothetical $100,000 account.

[ ($66,666 x 6% loss) + ($33,333 x 0% loss) ] = $62,666 + $33,333 = $95,999
(or 4% lower than the initial $100,000)

But what if you used that remaining cash position (1/3 of the account) to make a short term purchase of an inverse leveraged (2:1) fund? If the market lost the same 6%, the fund would gain 12%. And more importantly, your account would lose no ground.

[ ($66,666 x 6% loss) + ($33,333 x 12% gain) ] = $62,666 + $37,333 = $100,000
(or equal to the initial $100,000)

The immediate upside is clear, with several potential 'bigger picture' fringe benefits included. One of them is simply that this strategy allows you to ride out rough periods, without forcing you to bail out of stocks because the short-term pain has gotten too great. Another plus is the technique can buy you time when things are unclear, and you want to see how things shake out over a few days.

Anyway, if you're serious about hedging a long-only portfolio, this is definitely worth a thought. By the way, the short-term redemption fees usually don't apply for funds like this…just be sure to check with the fund and/or your broker first, as the fees or commissions may affect how often you choose to hedge with funds.

As always, a caveat…..

This is obviously not a long-term solution. In fact, in our example, it was pretty much guaranteed to be a zero-sum game no matter which direction the market went. So, you don't want to stay hedged longer than you have to. Otherwise, you'll literally go nowhere. But, for those looming short-term pullbacks, this can be an easy way to play defense. The trick (as always) is knowing when to add or remove the hedge.