Investment Strategies the Best Investors Use - Hedging
The stock market had been moving higher recently on the idea that Europe's credit issues will be manageable.
The recent rally was fueled by news out of Europe that Germany and the European Union will support Greece's efforts to restructure their debt.
The credit issues that the world financial markets are dealing with will be with us for years to come, and there will be new concerns at times.
However, as history has shown, these flair-ups are more likely to produce a market correction rather than a bear market.
It appears that this latest news fits this scenario as well.
The domestic economy continues to under-perform, and recent economic data confirms the weakness.
Investors are concerned that the economy should be doing better by now, and that the Federal Reserve cannot save it with "QEIII" or whatever the next stimulus package may be.
With interest rates low and growth reasonable, investing for a turn-around in the fortunes of public companies seems logical.
But the weak economy is also the primary reason why investors are not more bullish.
Part of this has to do with investor sentiment.
If an investor has money in the market, but doesn't feel secure in their job or doesn't have the money to do what they would like to do, then it can erode his/her faith in the system.
This can be a self-fulfilling dynamic.
Ideally, there is a real improvement in the economic data but investors don't see it as meaningful, and their bearishness prevents them from seeing the opportunity objectively.
Investors should remain invested because the market's trend and valuation, combined with cautious investor sentiment and favorable monetary policy, are all positive indicators of a bull market.
Having too strong of economic growth could actually upset this scenario, as sentiment and monetarily policy would likely be unfavorable, leading to unattractive valuations.
Accepting the volatility as a consequence for the bullish case has compensated investors historically.
Investors that also have a way to actively manage risk will have an advantage in these uncertain times.
While hard to be wildly bullish given the economy, many market participants are positioned net long after concluding that the investment environment is reasonable.
The best investors use hedging strategies to periodically manage risk and the potential downside of the market.
To align a portfolio with the market environment without the emotion that produces trades inconsistent with a well thought out investment strategy, use hedging models to manage market exposure that allow you to maintain your underlying portfolio.
In order to execute a hedge overlay, two things are needed; a signal from a hedging model for trade timing, and a security to trade when the signal is given.
Hedge overlay signals can be generated as discretionary calls or systematic models.
While both are options, the use of discretion can be difficult in fast-moving markets.
Systematic models excel at keeping trades objective, but can be hard to program to signal all of the different market decline scenarios.
A combination of the two is frequently a solution.
Securities that have leverage are often used for overlays because a small cash investment will effectively give the investor a large exposure.
Examples of leveraged securities are leveraged Exchange Traded Funds ("ETFs"), options, and futures.
We will focus on leveraged ETFs.
There are a few ETFs that use leverage to magnify market exposure, both positive and negative.
For instance, there are ETFs that give an investors twice the upside market exposure when purchased, and others that gives twice the downside market exposure when purchased.
This last type of security is called an Inverse ETF.
What's interesting about inverse ETFs is that, just like regular securities, you purchase them rather than sell them short, as the shorting is done within the ETF structure.
Using an inverse ETF for hedging purposes can be an effective way to deploy a hedge overlay.
For example, assume a double (2x) inverse ETF is purchased with 15% of a portfolio when a hedging signal is generated.
Once purchased, tt would effectively negate 30% of the portfolio market exposure.
Assuming in this example that the portfolio is 85% long before the hedge, after this hedge it would be 55% net long (85% - 30%).
Determining how much to hedge is a function of the market outlook and the risk tolerance.
In the example, if the market forecast was for a 10% correction and the portfolio exposure after the hedge was 55%, then it could be concluded that the portfolio would experience a 5.
5% draw-down.
Assuming this amount of draw-down was comfortable, this amount of hedging would be appropriate.
The recent rally was fueled by news out of Europe that Germany and the European Union will support Greece's efforts to restructure their debt.
The credit issues that the world financial markets are dealing with will be with us for years to come, and there will be new concerns at times.
However, as history has shown, these flair-ups are more likely to produce a market correction rather than a bear market.
It appears that this latest news fits this scenario as well.
The domestic economy continues to under-perform, and recent economic data confirms the weakness.
Investors are concerned that the economy should be doing better by now, and that the Federal Reserve cannot save it with "QEIII" or whatever the next stimulus package may be.
With interest rates low and growth reasonable, investing for a turn-around in the fortunes of public companies seems logical.
But the weak economy is also the primary reason why investors are not more bullish.
Part of this has to do with investor sentiment.
If an investor has money in the market, but doesn't feel secure in their job or doesn't have the money to do what they would like to do, then it can erode his/her faith in the system.
This can be a self-fulfilling dynamic.
Ideally, there is a real improvement in the economic data but investors don't see it as meaningful, and their bearishness prevents them from seeing the opportunity objectively.
Investors should remain invested because the market's trend and valuation, combined with cautious investor sentiment and favorable monetary policy, are all positive indicators of a bull market.
Having too strong of economic growth could actually upset this scenario, as sentiment and monetarily policy would likely be unfavorable, leading to unattractive valuations.
Accepting the volatility as a consequence for the bullish case has compensated investors historically.
Investors that also have a way to actively manage risk will have an advantage in these uncertain times.
While hard to be wildly bullish given the economy, many market participants are positioned net long after concluding that the investment environment is reasonable.
The best investors use hedging strategies to periodically manage risk and the potential downside of the market.
To align a portfolio with the market environment without the emotion that produces trades inconsistent with a well thought out investment strategy, use hedging models to manage market exposure that allow you to maintain your underlying portfolio.
In order to execute a hedge overlay, two things are needed; a signal from a hedging model for trade timing, and a security to trade when the signal is given.
Hedge overlay signals can be generated as discretionary calls or systematic models.
While both are options, the use of discretion can be difficult in fast-moving markets.
Systematic models excel at keeping trades objective, but can be hard to program to signal all of the different market decline scenarios.
A combination of the two is frequently a solution.
Securities that have leverage are often used for overlays because a small cash investment will effectively give the investor a large exposure.
Examples of leveraged securities are leveraged Exchange Traded Funds ("ETFs"), options, and futures.
We will focus on leveraged ETFs.
There are a few ETFs that use leverage to magnify market exposure, both positive and negative.
For instance, there are ETFs that give an investors twice the upside market exposure when purchased, and others that gives twice the downside market exposure when purchased.
This last type of security is called an Inverse ETF.
What's interesting about inverse ETFs is that, just like regular securities, you purchase them rather than sell them short, as the shorting is done within the ETF structure.
Using an inverse ETF for hedging purposes can be an effective way to deploy a hedge overlay.
For example, assume a double (2x) inverse ETF is purchased with 15% of a portfolio when a hedging signal is generated.
Once purchased, tt would effectively negate 30% of the portfolio market exposure.
Assuming in this example that the portfolio is 85% long before the hedge, after this hedge it would be 55% net long (85% - 30%).
Determining how much to hedge is a function of the market outlook and the risk tolerance.
In the example, if the market forecast was for a 10% correction and the portfolio exposure after the hedge was 55%, then it could be concluded that the portfolio would experience a 5.
5% draw-down.
Assuming this amount of draw-down was comfortable, this amount of hedging would be appropriate.