A Diversified Safer Way To Hedge Against Stocks Using ETFs

Post on: 11 Июнь, 2015 No Comment

There are plenty of ways that you can hurt a man and bring him to the ground.

You can beat him, you can cheat him, you can treat him bad and leave him when he’s down.

Queen — Another One Bites The Dust

Over the last 12 months, most efforts to hedge against U.S. stock risk have proven to been an exercise in disappointment. And that’s if you merely chose milder forms of hedging, such as losing dollars with numerous put options or losing opportunity with excess cash. If you boarded the bear train with funds like ProShares UltraShort S&P 500 (NYSEARCA:SDS ) or ProShares UltraShort NASDAQ 100 QQQ (NYSEARCA:QID ) — if you did not have an exit strategy for being on the wrong side of an ever-appreciating stock market — the destruction to your portfolio may have humbled and overwhelmed. Year-to-date, SDS has shed approximately 25%.

However, hedging against stock risk does not have to be an exercise in dust-ingesting humiliation. Problems arise when one chooses to shoot for the moon on a gamble, such as shorting or employing inverse leverage with daily compounding inverse ETFs. Problems also arise when one looks to a singular asset for all the answers. Investment-grade U.S. treasuries may be great, unless you’ve chosen a single asset with an unfavorable duration or poor liquidity. Treasuries may also be limiting in the fact that sovereign debt from other nations often provide an effective hedge without the over-reliance on U.S. debt alone. Cash can be king in troubled times for stocks, though it often leaves an investor feeling stuck like a deer in the headlights, searching for a time to get back in. Similarly, if the cash is represented by the almighty buck, it ignored the effectiveness of a variety of global currencies with historically negative correlations with stocks.

In essence, if you peruse the Internet for ways to hedge against a downside stock slide, you are unlikely to discover a diversified basket. Instead, you will probably be told the same old dance and song. Go short. Buy bonds. Grab some put options. Hide in cash. Heck, you may even be advised to do nothing at all, since most financial professionals carelessly fall back on a buy-n-hold-hope approach.

Keep in mind, shorting positions or purchasing leveraged inverse funds does not simply involve the risk of an accurate prediction. It typically requires an investor to become an extremely active trader. Meanwhile, put options can be expensive when establishing multiple portfolio positions, not to mention that they have limited lifespans. And once again, neither cash nor U.S. bonds may properly diversify one’s hedge, since both are denominated in a single currency.

Each of these hedging approaches do have value, or you would not read about them in your Google searches. What’s missing is the fact that none may be suitable on its own. And that’s why one of the most important new developments in asset management is multi-asset stock hedging.

If you investigated non-stock assets that have shown appreciation and/or preservation of capital potential in stock downtrends… what might you find? Chances are, you would learn that the type of bonds that tend to hold up and/or grow the best are TIPS, zero-coupon treasuries, longer-term treasuries, Japanese Government Bonds (JGBs), German bunds and munis. You would also have found capital flight into safer haven currencies, including the U.S. dollar, the Japanese yen, and the Swiss franc. Granted, the yen may not seem like a safer haven, until one realizes the power of a rapidly unwinding carry trade. A precious metal like gold has also demonstrated effectiveness and consistency as a hedge in bearish stock downtrends.

It follows that my company Pacific Park Financial, Inc. used all of these asset classes to develop the first and only multi-asset stock hedge index with FTSE, the global leader in indexing. The FTSE Custom Multi-Asset Stock Hedge Index launched today, 11/19/2014; data is available dating back to 6/30/2011.

In essence, the index tracks ETFs that represent each of the above-mentioned ten asset categories. Rules of the equal-weighted index provide for semi-annual rebalancing. And while the specific components of the index represent asset classes that have been around for many decades, the ETFs themselves have not. This is the reason that data is only available since June 30, 2011.

By the same token, we can identify the performance of the index in the most meaningful stock downturn over the last three years — the euro-zone crisis. The high-to-low for the S&P 500 occurred from 7/7/2011 to 10/3/2011 with a drawdown of -18.8%. The FTSE Multi-Asset Stock Hedge Index chimed in at 12.4%. The 300-basis-point differential occurred without leverage or shorting stocks; rather, asset classes with a history of performing well during times of stock stress offered a diversified method for hedging.

At this moment, it is not possible to invest in the index directly. Yet investors who worry about a serious shock to stocks can look to combine several index components for diversified hedging. For example, zero coupon bonds can be acquired by PIMCO 20+ Year Zero Coupon (NYSEARCA:ZROZ ) and longer-dated U.S. Treasuries may be picked up via iShares 10-20 Year Treasury (NYSEARCA:TLH ). For those who understand why the yen carry trade could rapidly unwind, there’s CurrencyShares Japanese Yen Trust (NYSEARCA:FXY ). Historically speaking, the Swiss franc and gold have also provided shelter; CurrencyShares Swiss Franc (NYSEARCA:FXF ) and SPDR Gold (NYSEARCA:GLD ) both fit the bill.

One may have a tougher time gaining meaningful access to Japanese government bonds (JGBs) and/or German bunds. Yet the point of this article is to give investors alternatives to the higher-risk nature of shorting as well as the limited scope of single-asset stock hedging. A multi-asset approach to hedging against stock risk provides desirable diversification.

It is also worth noting that, while all of the ETF components of the FTSE Multi-Asset Stock Hedge Index were not in existence during the epic bear collapse circa 10/2007-3/2009, the representative assets were. An equal-weighted combination of inflation-protected securities, zero-coupon treasuries, longer-term treasuries, Japanese Government Bonds (JGBs), German bunds, munis, the U.S. dollar, the Japanese yen, the Swiss franc and gold collectively provided positive returns in the time period. That’s a far cry better than enduring the 50%-plus losses in 2008’s wealth-destroying bear.

Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc. a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.