Thursday, December 11, 2008

Taking a Short Walk

In 2008 it turns out, many investors were taking a long walk off a short pier. The cement overshoes many of us were wearing didn’t help either. This was the end result of staying at the party, drinking the punch far too late into the night.

People smarter than me had left the party earlier in the evening having munched a few canapés, partaken only lightly of the punch, sold short and gone home before things got ugly.

Those of us who kept thinking the markets were due for a fall were proven right in our conviction, but dead wrong in having taken any action that would have proven prescient. So now that the shock – and hangover - has mostly worn off, what do we do? The markets have set so many records for volatility, only the most diligent day traders have been making any money.

Enter The Hedge

In a perfect world, somewhere in a perfect parallel universe, exists the perfect hedge. The perfect hedge goes up as much as the thing being hedged goes down, and vice versa, all without adding to the investor’s costs. But let’s get real. Hedging is inherently imperfect and of course it isn’t free.

In a market as volatile as we’ve experienced lately, many investors would probably be happy if the value of their risk capital accounts remained roughly the same from day to day. Too many of us have gone long (buying) when we should have gone short (selling) and gone short (selling) when we should have gone long (buying) – sometimes all in the same day. What, you too?

The traditional method of going short is to sell borrowed stock, buying it back after it declines (called “covering”), and pocketing the price difference (minus transaction costs). For those not willing to do the immense amount of research required to decide which stocks to short, Exchange –Traded Funds (ETFs) can also be sold short. ETFs are mostly constructed to follow market or sector indices – selling them short gives exposure to the same market or sector on the down side. An investor could construct a simple hedge of the S&P 500 Index by buying an ETF that emulates the index (sample ticker: IVV) and then selling the same ETF short to protect the long position by a pre-determined percentage. One of the advantages of short selling is that money flows into the account from the sale and some of that money (subject to margin requirements) can be used for re-investment. IRAs and qualified plan accounts (e.g., 401ks) are not allowed to sell short, but there are other ways to hedge long positions (keep reading).

Inverse Exchange-Traded Funds

Shorting a market or sector can also be accomplished by buying (going long) inverse ETFs. Inverse ETFs are based on derivative contracts that are designed to give an investor downside exposure to a market or sector. The share value of the ETF moves inversely to the value of the market or sector – by owning (long) the inverse ETF, an investor is short the market or sector. If the market goes up 1%, the matching inverse ETF goes down 1% and vice versa.

There is a growing sector of the ETF market that uses leverage to increase exposure to the desired market or sector e.g., 2 X the S&P 500 Index (sample ticker: SSO). If the S&P 500 goes up 1%, SSO will go up 2%. If the S&P 500 goes down 1%, then SSO goes down 2%. (Not accounting for tracking error which includes expenses charged by the ETF). There are now also many 2 X INVERSE ETFs in which one can invest (sample ticker: SDS). If the S&P 500 goes up 1%, then SDS goes down 2%. If the S&P 500 goes down 1%, then SDS goes up 2%.

A simple hedge of the S&P 500 Index could be constructed with $6,700 invested in IVV (long S&P 500) and $3,300 invested in SDS (2 X Inverse S&P 500). If the two funds are perfectly negatively correlated, the total invested value of $10,000 would change very little over time. Since we live in the imperfect world (home of the imperfect hedge) the total value would change, but it would remain fairly close to what we started with. Since the 2 X inverse ETF moves twice the % of the long ETF, one only has to commit about half the amount of funds committed to the long side to implement the hedge on the short side.

IRAs and other qualified plan accounts are not allowed to sell short, but they can buy inverse ETFs – effectively shorting by going long.

With the 2 X Inverse construction, investors can decide how much of a long position they wish to hedge. As described above, the 2/3rd - 1/3rd recipe approximately maintains a total dollar value – very handy during volatile daily swings. A long-bias hedge could also be constructed with a lesser % commitment to the inverse ETF.

There are Inverse ETFs available for many different market and sector indices. Investors can hedge their existing long positions by buying the inverse ETF that most closely matches the long position. It’s a good idea to review charts comparing the history of the long-short pairing to see how closely (negatively) correlated the pairing has been.

The chart below illustrates the negative correlation of the S&P 500 Index (ticker: IVV) and a 2 X Inverse ETF tracking the S&P 500 Index (ticker: SDS).

Hedging with inverse ETFs won’t keep you from walking off the pier, but they can turn those cement overshoes into a life raft.


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