Market Beat: Hedging for portfolio protection
Hedging is a defensive tactic that can be used to help protect your portfolio.
It’s kind of like buying insurance on your home, it costs money, you hope that you never need it, but will be glad that you have it if the need ever arises.
The term “hedging” goes back to medieval days when property owners would plant hedges around their homes to act as a fence. Its use as an investment term goes back hundreds of years.
Today there are numerous investment vehicles available to use as hedging tools and their use does require some sophistication. One area of the rapidly expanding exchange traded fund and exchange traded note universe has been in leveraged and inverse funds. The difference between exchange traded funds and exchange traded notes is that exchange traded funds are typically backed by the underlying investments, while exchange traded notes are back by the issuing entity.
Inverse funds will move in the opposite direction of a particular investment, like a major stock index or commodity. So, if the index goes down the inverse fund will go up. Leveraged funds are similar but are designed to move two or three times the amount that the underlying investment does. Leveraged funds can be inverse or move in the same direction as the index but with greater price movement.
One caution about using these types of funds as a hedge is that they are not long-term investments, like stock index funds are. They will move opposite the index for a limited amount of time but will not track over longer time frames. They tend to lose value over time due to a form of price decay, referred to in the futures markets as the contango effect. The funds are based on futures contracts will lose value over time if the price of the underlying does not move.
When using inverse funds as a hedge, you need to decide the time frame that you want to hedge for and select the appropriate fund. For example, you may want to have a hedge during times when there are known events on the calendar that could have an impact on the market, like elections or Fed meetings. Decide in advance when you’re going to put the hedge on, in what quantity and when you’re going to remove it. There are a wide variety of hedging tools and their use can be complex.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.