By Scott’s Investments

Contributor

03/22/11 — 05:33 PM EDT

The following commentary comes from an independent investor or market observer as part of TheStreet’s guest contributor program, which is separate from the company’s news coverage. The opinions expressed are those of the author and do not represent the views of TheStreet or its management.

NEW YORK (Scott’s Investments ) — Market volatility and drawdowns remind us of the role that hedging can have in portfolios. Hedging in its simplest form is purchasing securities in order to reduce portfolio risk. The purchased securities are intended to have negative correlation to the remainder of the portfolio in order to help offset any potential losses in the portfolio.

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Holding uncorrelated assets, such as stocks and bonds, are one of the most popular methods for reducing portfolio risk since historically stocks and bonds are relatively uncorrelated. There are other methods for hedging downside risk and this article explores four methods for hedging long equity positions.

Moving Average

One of the more popular methods for minimizing downside risk and one I track frequently on Scott’s Investments is to exit long positions when they fall below a long-term moving average. This may not technically be a hedge, since the entire position is exited. However, as Faber showed in The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets. it is an effective method for reducing volatility and risk in a portfolio.

There are other options for investors who hold individual equity positions and hedge. For example, say you hold a position in two stocks, ABC and XYZ, and wish to hold both stocks for the long term. However, the overall equity market has you a bit nervous and has recently begun to struggle, showing signs of weakness. One option would be to short the overall equity market, and one of the simplest ways to do so would be via a 1x inverse ETF such as (Proshares Short S&P 500 (SH ), which seeks daily investment results that correspond to the inverse of the S&P 500 Index. You could also use an inverse small-cap, international, sector, etc. ETF, depending on the long positions you currently hold.

I most recently back-tested an example of this moving average hedge system in March 2010. I used AlphaClone to generate my individual stock holdings. I then shorted the S&P 500 in an equal amount (100% hedged) only when the S&P 500 closed below its 10-month simple moving average. The system did not have a down year since 2000. While much of the performance can be attributed to AlphaClone’s ability to find stocks with hedge fund support, the hedge did its job in reducing volatility and drawdowns:

Relative Strength

Using ETF Replay. we can compare the relative strength and volatility of ETFs and backtest various ETF strategies.

Assume we hold a portfolio of five ETFs representing five major asset classes: Vanguard Total Bond Market ETF (BND ) (bonds),PowerShares DB Commodity Index (DBC ) (commodities), Vanguard FTSE All-World ex-US ETF (VEU ) (international equities), Vanguard REIT Index ETF (VNQ ) (REITs) and Vanguard Total Stock Market ETF (VTI ) (U.S. equities). A buy-and-hold portfolio since 2008 had 22.4% volatility and a -46.28% drawdown (despite being allocated across 5 seemingly diverse asset classes) and, frankly, disappointing results (results from ETF Replay include dividends):

I created a portfolio of SPDR S&P 500 (SPY ) (long S&P 500), SH (short S&P 500) and iShares Barclays 1-3 Year Treasury Bond (SHY ) (short-term Treasuries, used as a close proxy for cash). I went long whichever of the three had the highest combined ranking as determined by the highest relative strength over the past three months and 20 days and the lowest volatility over the past 20 days. The system rebalanced semimonthly (for those looking to limit turnover, the monthly rebalance returns were slightly lower but similar to semimonthly), produced the following results. While volatility was high, which is to be expected when only holding one position, returns far outperformed a long-only strategy (SPY), which was also to be expected given the market volatility of 2008:

How could one use this information to hedge? If we’d held 50% of a portfolio in the five-ETF portfolio referenced above and allocated the other 50% to the SPY-SH-SHY strategy, we’d have reduced volatility and drawdowns during one of the most volatile periods in recent history and still produced solid returns. This is mainly owed to positions in SH, which hedge the positions in the five-ETF portfolio that were highly correlated in 2008. I used a 50% allocation to both strategies for simplicity and not as a recommended allocation:

Market Conditions

A third hedging strategy is to based long/short positions on overall market conditions. There are myriad ways to gauge market conditions, and how one hedges these conditions depends on your timeframe and current portfolio. However, assume we hold a portfolio of U.S. equities or U.S. equity ETFs and wish to hedge them during unfavorable market conditions.

I am a big fan of the analysis at dshort.com. and pay close attention to the P/E Ratio Market Valuation updates. Ideally, we could employ a hedge when the market is overvalued. However, markets can stay over- and undervalued for lengthy periods of time, sometimes years. Thus, basing a hedge on relative long-term market valuation alone can be a costly and lengthy experiment.

Stockscreen123 has devised a timing system suitable for longer-term investors that has historically still reacted quickly enough to serve as a hedge during unfavorable market conditions. The system uses two factors to determine market conditions, assumingconditions are favorable for equity investing if EPS estimates are rising and if valuations are reasonable.

1. The estimates test is whether the five-week moving average of the aggregate of the consensus current-year estimates for S&P 500 companies is above the 21-week moving average.

2. The valuation test is based upon risk premium, specifically whether the S&P 500 risk premium (earnings yield minus 10-year Treasury yield) is above 1%

When conditions are favorable, one would be long equities (hold SPY) and during unfavorable conditions, short equities (hold SH). Rebalancing every four weeks for five years results in the following equity curve (red line) compared with the S&P 500 (blue line):

During periods of high volatility and market drawdowns, this system performed well, moving inversely to the S&P 500, and could have served as a functional tool for determining when to hedge equity (or other) positions.

The current signal indicates favorable market conditions and a position in SPY.

Technical Analysis

Technical analysis can also serve as a method for determining when to hedge long positions. If an investor is comfortable and skilled enough in conducting his or her technical analysis, then during periods of high uncertainty or unfavorable technical setups, either in a market index or in an individual position, a hedge may be appropriate. The hedge could again be a short position in an index ETF or could be an options position on an individual holding.

Technical analysis is a broad subject with many tentacles, so a comprehensive review is not possible. However, as a general rule, support and resistance lines and trend lines are good starting points for analyzing technical setups, and I wrote about one such setup last week with Chris Vermeulen giving us an example in this chart of what he saw headed into the week of the March 14 (chart courtesy of The Gold and Oil Guy ):

This article should not be considered a complete list of hedging methods as there are myriad others ways to hedge a portfolio (options being a popular method not discussed here). Hopefully it served as a starting point for further considerations on how and when to hedge equity positions and your portfolio as a whole.

Returns discussed excluded commissions and taxes.

At the time of publication, author had no positions in stocks mentioned.

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