Hedging in an IRA

Individual Retirement Accounts, IRAs, are tax-advantaged retirement accounts, contributed to by an individual, not their employer. A great thing about an IRA is that almost anyone can open one. This is important since less than half of American workers are entitled to an employer sponsored retirement program such as a 401(k) or profit sharing plan. You can utilize an IRA as a hedging vehicle for other accounts. Or you can roll-over your IRA or 401k into a self directed IRA for greater flexibility.

The vast majority of retirement assets in IRAs are invested in stocks, bonds, ETFs and mutual funds. This is because the average custodian (the company that oversees your money like Fidelity or Schwab) has approved these classes of investments. They are predominantly ‘long only’ investments, designed for buy and hold investors. Over time, the power of compounding is a powerful force for long-term stock investing, so this matches perfectly with a long-term horizon of many IRA account holders. But, if you are worried about protecting the gains you’ve already enjoyed, your options are limited. Some companies allow hedging strategies in an IRA account, such as buying protective put options or inverse ETFs, but some do not. We will update which companies allow these alternative assets classes. If your IRA custodian does not allow these alternatives asset classes you might consider opening up a ‘self-directed’ IRA.

Inverse ETFs in a Self Directed IRA

With a self-directed IRA, you take a more active role in your investment decisions, in a tax-advantaged manner. The menu of investment options really opens up, typically including gold and silver coins, real estate, mortgage notes, even a closely-held business. Other allowable investments may include hedged exchange traded funds as well as inverse or short ETFs, all designed to reduce risk. These products should hold up better in a severe bear market than traditional investments and act as a hedge against a bear market and volatility. Depending on your risk tolerances and other variables, this is an idea worth seriously considering.

The tricky part can be finding a custodian that will allow these alternative investments. Many traditional custodians are banks or mutual fund companies who may not be supportive of these strategies for reasons usually having to do with their own self-interest (harder to charge fees). But this is changing somewhat as there is a clear demand for hedging strategies by many of their customers.

Should I Roll-Over my 401(k) into an IRA?

There is much greater flexibility in terms of investment options with IRAs compared to employer-sponsored retirement accounts such as 401(k)s. Most 401(k)s offer a money market fund along with maybe a dozen stock or bond mutual funds. In addition to greater investment flexibility, IRAs are typically a cheaper option than a 401(k) since IRAs usually allow exchange traded funds which are often significantly lower cost than mutual funds (and probably more liquid). Additionally, alternative ETFs offer more flexibility than simple buy and hold strategies. The money you save in annual fees by being in an IRA instead of a 401(k) could be allocated for a dedicated hedging strategy. This basically provides some insurance for your portfolio and is part of a tactical, actively managed strategy.

Other than ‘going to cash’ in a money market fund, options for downside protection in a 401(k) are probably limited. But not in an IRA. Assume you have an old 401(k) from another job. Instead of rolling it all into your current 401(k) (as you’ll be advised to do to save on ‘fees’) consider rolling some of it over into an IRA. Once funds are in the IRA you can utilize different hedging strategies. Depending on the suitability given your risk tolerance and individual situation, inverse ETFs might be purchased (ideally on an intraday basis) to hedge mutual fund exposure in a 401(k). This is because mutual funds can’t be sold until the closing price of the day, even if the order is placed in the middle of the trading day. Hedging strategies should consider these liquidity constraints.

Another strategy, if available in the IRA, is using options to hedge the downside of your portfolio. Protective put options cover this area in a simple way because as the stocks you own either in an IRA, 401(k) or even non-retirement brokerage account go down in a bear market, the value of the put option will increase, offsetting some of the losses. Options trading is sometimes perceived as risky but employing basic option strategies, such as index put options, can actually reduce market risk in a portfolio. This is the essence of hedging. We will keep you posted on which firms offer IRAs that offer options trading and inverse ETFs. Short-selling in an IRA is typically not-allowed due to the potential for unlimited losses, theoretically.

Finally, 401(k)s have very limited hedging options, except for going to cash, typically in a money market fund. If you’re concerned with preservation of capital, your IRA should also have more choices with regards to the safest type of money market accounts, Treasury-Only money market funds.