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In the world of finance, hedging is often thought of as a bad word. Banking failures and hedge fund bankruptcies have cast it in a bad light and left a bad taste in the mouths of investors who have experienced such disasters first-hand. Despite the negative press, hedging is actually a risk-reduction strategy used to create a safety net for investments.

Most people might not be aware of it, but hedging is a concept we use in our everyday lives. If you own an automobile, you probably have it insured to protect yourself from unforeseen losses. The same thing goes for any type of insurance whether its for your home or even for yourself with a life policy, youre hedging against loss.

Hedging in the stock market is simply taking out insurance on your positions. In other words, if youre bullish on a stock that you own, you may want to sell a covered call or buy a put to protect the shares just in case of a pull-back. As with all hedging, you tend to reduce your total upside potential unlike just going “all-in,” but you also limit your downside risk making your portfolio more stable.

A Closer Look At Professional Money Management: Hedge Funds

Hedge funds are touted as the ultimate portfolio designed to profit in any type of market condition while also reducing overall risk. They invest in multiple asset classes such as equities, bonds, options, currencies and more, making them more flexible when it comes to repositioning money and weathering unexpected market events. Because they are managed more intensely than other products and engage in sophisticated strategies, only accredited investors – generally defined as an individual with a net worth of at least $1 million or annual income of $200,000 in the past 2 years and expected to continue into the future – are able to buy into hedge funds.

These specialized investment vehicles employ a number of different strategies that may include leverage and derivatives or take on a more conservative approach and avoid leveraged positions. Most hedge funds attempt to reduce risk from bear markets by shorting stocks or applying derivatives. Instead of following indexes like the S&P 500, hedge funds aim to beat market averages and deliver outstanding results whether the market rises, falls, or trades flat.

Common Misconception: All Hedge Funds Are Risky

Many institutions and individuals invest in hedge funds for the diversification benefits. If you have a portfolio of investments, adding an uncorrelated (and positive-returning) asset will reduce total portfolio risk. Hedge funds because they employ derivatives, short strategies, or other non-equity investments tend to be uncorrelated with broad stock market indices. They also eliminate the need for “market timing” because of their exposure to long and short strategies which can reduce volatility and provide long term solutions.

Not all hedge funds are created the same and can be identified through just over a dozen distinct investment strategies. The volatility of each type varies depending on its investment theme and ranges from very little to very high. Heres a list of hedge fund investment styles and a short descriptor for each:

• Convertible Arbitrage – This fund strategy consists of holding a convertible bond long while selling the underlying stock short. Bond coupon payments generate some revenue while the majority of the profit is made off of the inefficiency in pricing differences. Trading strategy: market-neutral .
• Dedicated Short-Bias – An overall “bear” position is taken with this strategy through shorting stocks and profiting from market downturns. Some long exposures may be implemented as well to hedge against market gains. Trading strategy: short .
• Distressed Securities – This is an event-driven strategy that may employ taking both long and/or short positions both in the debt and equity of the underlying company. It focuses on troubled companies that may be on the verge of bankruptcy and relies on deep value analysis. Trading strategy: market-neutral .
• Emerging Markets – This is an equity and bond type strategy that invests primarily in emerging market countries around the world. These markets may have unique trading restrictions which can disallow derivative usage making hedging more difficult to execute. Trading strategy: long .
• Equity Market-Neutral – Long and short positions are taken in order to eliminate systemic risk. These funds may have equal distributions on the long and short side giving them a beta of essentially zero. Trading strategy: market-neutral .
• Event-Driven – Company news, mergers, acquisitions, and corporate restructuring are all triggers for this type of hedge fund. Short term gains are eyed by taking advantage of pricing inefficiencies and the underlying volatility. Trading strategy: market-neutral .
• Fixed Income Arbitrage – Focusing on debt instruments like bonds, this strategy attempts to find pricing inefficiencies by both buying and selling fixed income products. Eliminating interest rate risk is a major benefit of this fund type. Trading strategy: market-neutral .
• Fund of Funds – A fund of funds is simply a hedge fund that contains investments in multiple hedge funds under one big umbrella. Trading strategy: varies .
• Global Macro – One of the more common fund types, this is more or less a no-holds barred bullish portfolio. Leverage and derivatives are applied liberally to directional bets on stocks, bonds, currencies, commodities, rate-swaps, and virtually anything else the fund manager believes will appreciate in value. Trading strategy: long .
• Long/Short Equity – This is another widely used strategy and, as the name implies, utilizes both long and short positions in stocks. It is not a neutral trading strategy however as it takes a primarily bullish stance in its portfolio. An example would be a fund that splits up positions with 30% short and 70% long creating an overall 40% long exposure. The fund may also increase bullishness by applying some or all of the money generated with shorting and using it to leverage the long side creating up to 130% long exposure. Trading strategy: long .
• Managed Futures – Primarily invested in commodities such as gold, silver, oil, corn, etc. this fund may take long or short positions depending on market conditions. Trading strategy: varies .
• Multi-Strategy Multiple strategies that include both long term and short term trading methods are utilized as well as various investment techniques such as trend charting and technical analysis. The fund manager has the ability to make directional bets based on their analysis giving this fund type ample flexibility. Trading strategy: varies .
• Statistical Arbitrage – Quantitative pricing models are used to identify minute inefficiencies in various asset classes. These funds are largely computerized and may make thousands of trades in a single day. Trading strategy: market-neutral .
• Value This strategy adheres to value principles in its investment selection, most closely resembling the approach taken by one of the most successful investment gurus, Warren Buffet. Only securities that are undervalued based on its intrinsic value are considered. This is a long term strategy as value may take time to be fully realized by the market as a whole. Trading strategy: long .

Hedging By Mixing Up Asset Classes

Hedging a position doesnt always mean buying and selling the same asset class. Stocks for example, can be bought long and sold short which creates a hedge but doesnt necessarily reduce risk. If you were to buy 100 shares of stock “A” and sell 100 shares of stock “Z,” you might be hedged against systemic market risk, i.e. a stock market crash, but it brings up new risks. The stock market may continue to climb resulting in a profit for stock “A”, but a loss in stock “Z.” A better way to hedge involves branching out into other asset classes to create a more diverse and risk-reducing strategy.

If we mixed options into our equity portfolio, we could open ourselves up to even more hedging scenarios. Taking from our previous example, we could do a number of different things depending on what we wanted to accomplish. If we had a bullish stance, but wanted to protect ourselves, we could buy stock “A” and sell a covered call which would cap our upside but give us some downside protection as well. If we were even more concerned about a possible correction or bear market, we might go a bit further by buying a put as well. The revenue generated by selling the covered call would help offset the cost of buying the put and limit our total risk where we would have minimal losses even if the worst case scenario happened.

We might have addressed some risk associated with volatile markets, but we still face other risks like foreign exchange risk and interest rate risk. A properly diversified portfolio will include investments in overseas markets that use a different currency than the US Dollar. If you had investments in Europe, then any profits would come in the form of Euros. If the Euro were to suddenly drop in value relative to the Dollar, then those gains will be reduced, or even eliminated by the time you convert it back to Dollars.

Addressing foreign exchange risk can be done in a couple of ways. You could short the Euro and long the US Dollar, creating a hedge that would offset any losses sustained when you converted the money. The strategy of selling of one currency and buying another is called a carry trade – something implemented primarily by large investment firms like hedge funds. The hedge created works both ways as well. If you were to engage in a carry trade without any foreign investments, you would be exposed to foreign exchange risk also – a risk that can be reduced by investing in the underlying international market.

Alternatively, you could engage in a currency swap. This is when 2 parties agree to exchange currencies for a set amount of time and then the currency reverts back. The same concept can be applied to hedge against interest rate risk as well. No matter what type of investment you have, theres always a hedge that can be made whether its through stocks, bonds, derivatives, futures, or swaps.

How a Well-Hedged Portfolio Protects You

The oft-repeated adage, the best offense is a good defense, fits portfolio management remarkably well. Managing risk is a key element in maintaining positive performance results year after year and is often overlooked by new entrants into the global markets who are seeking to chase returns. Lets explore how a well-hedged portfolio works when tested against hypothetical situations.