The higher the stock market climbs and the longer the current bull market lasts, the more prudent investors may hear a tiny voice in the back of their heads warning them about the next major downturn in stocks. After all, no bull market lasts forever, and the average bear market following a bull market has resulted in a drop of 41 percent in the U.S. stock market.
No investor wants to sit back and watch 40 percent or more of a retirement fund or other investment portfolio disappear into thin air. One method that investors can use to protect against risk is a technique called hedging.
Hedging is a bit like buying insurance for investments. It can be expensive, and it might not cover all losses, but it can potentially help soften the blow in the event of a market downturn. In the stock market, investors and portfolio managers hedge by buying securities that will likely rise in value as stock prices decline.
In other words, proper hedging would involve buying assets that are negatively correlated with the price of core portfolio holdings.
For example, airline stocks have historically demonstrated a negative correlation with crude oil prices. This negative correlation makes sense because airlines must purchase massive quantities of fuel, the cost of which is determined by oil prices. The more expensive the jet fuel, the weaker the airlines’ profits.
Ironically, airlines have taken steps to reduce their negative correlation with oil prices by hedging against fuel prices themselves. Airlines often purchase options and futures contracts based on the current price of oil to lock in fuel prices as a certain fixed cost. In the event that fuel prices surge, the value of these hedges will also increase, offsetting much of the potential cost increases for the airlines.
For investors, the idea of hedging to protect against losses can sound like a great plan. In reality, mitigating risk while protecting returns can be extremely difficult. When an investor buys two assets that are negatively correlated, one of the two assets is destined to depreciate in value no matter which direction the market goes. In other words, by hedging a portfolio, investors are simply reducing the potential risk associated with their portfolio in exchange for a portion of their potential rewards.
According to Mike Loewengart, vice president of investment strategy at E-Trade, there are plenty of hedging instruments out there for investors who are long in U.S. stocks.
“For investors today, hedging has truly never been easier or more cost-effective,” Lowengart says. “There are countless ETFs investors can deploy for hedging – from active ETFs that short the market to currency ETFs that serve as a substitute for complex futures or options positions.”
For example the ProShares Short S&P 500 (ticker: SH) exchange-traded fund is designed to deliver the inverse daily return of the Standard & Poor’s 500 index. The fund holds complicated financial instruments that are designed to deliver a 1 percent gain when the S&P 500 delivers a 1 percent loss and vice versa.
The ProShares Short QQQ ETF (PSQ) is designed to deliver the inverse daily return of the Nasdaq 100 index. The ProShares Short Russell 2000 ETF (RWM) is an inverse ETF negatively correlated to the Russell 2000 small-cap index.
While these hedging instruments can help reduce losses in the event of a stock market sell-off, they also eat into gains each day the bull market continues. In addition, due to the nature of the assets they hold and the fees associated with managing these funds, they tend to decline in value over time even if the indices they are tracking trade mostly flat.
In principle, it’s good for long-term investors to be thinking about ways to protect against large swings in the stock market. However, Mark Hebner, CEO of wealth advisory firm Index Fund Advisors, says investors that are too worried about the next downturn probably have too much risk in their portfolios in the first place.
“Select the right risk exposure that matches your risk capacity and then there is no reason to hedge,” Hebner says.
Nicholas Colas, co-founder of DataTrek Research, says protecting against stock market downturns can be as simple as making sure to maintain a balanced, diversified investment portfolio.
“Investors should always be thinking about the balance of stocks and bonds in their overall portfolio,” Colas says. “If the strong equity market has lifted the percentage of stocks in their portfolio too much, they should consider selling some of those holdings to maintain the right long-term balance.”
Even though hedging is cheaper and easier than ever, Loewngart says it’s not necessarily right for every investor.
“For long-term investors, downside protection doesn’t have to be complex,” Loewengart says. “Maintaining a well-diversified portfolio composed of stocks and bonds can be an effective way to mitigate risk over the long term.”
Hedging investment portfolios can be costly and it comes with its own set of risks. Instead of hedging, investors losing sleep over the next market sell-off should consider taking a simpler approach to managing risk by simply rebalancing their portfolios. By selling stocks and buying bonds, certificates of deposit or other lower-risk assets, investors can…
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