Hedging Stocks
What’s the Concern about Stocks?
The extension of easy credit, and innovative new investment products, has swelled global asset values to over $70 trillion in 2015.* The United States alone accounts for $17 trillion of that total, tripling in value off of the financial crisis lows of 2009. This rebound occurred from quantitative easing and low interest rates. These low interest rates may have had a dangerous effect on investors, both institutional and individual. On the institutional side, pension plans, endowments and many financial companies have had to take on increasing risks to achieve their required return objectives. A similar occurrence can be seen with individuals, as many baby boomers and retirees simply can’t live on today’s low interest rates. Hedging stocks and other holdings in your portfolio will be of utmost importance in the coming years as we are long overdue for a serious bear market.
With the click of a mouse, an investor in 2015 can have money invested in almost any conceivable market or sector in the world. This used to be a good thing since it diversified your portfolio (spread out the risk). The problem is, this blueprint has been repeated so many times now that mutual funds and ETFs all hold essentially the same stocks.
Valuations have never been higher in today’s equity markets. The dividend yield for the US markets was only lower at the tech bubbles height in 2000. Not coincidentally, margin levels registered 82% higher than at the tech bubble peak. Complacency has also never been higher. Stocks fluctuating are normal for stocks markets. the fear of a hefty sell-off is a good thing since it can keep investors in check and mindful of valuations and excessive risk. As counter-intuitive as it may sound, when a market goes straight up it is a sign of troubling things ahead. The volatility index or VIX has had a sustained period of low levels for years now. A similar extended level was seen in the buildup to the financial crisis.
If you looked under the hood of the car you might get worried. Today, the level of corporate buybacks has been a powerful buoy for the equity markets as corporations have used the cheap debt financing to buyback their own stock. This decreases the amount of tradeable shares outstanding (float) and can cause stock prices to shoot higher. The problem is, they have become the main buyer. Some argue this has essentially put the shareholders on margin.
Inverse ETFs are a valuable tool to protect a portfolio against a severe bear market. Most investors are saving for their retirements don’t think of the downside, they only follow overly optimistic projections and glide paths.
Hedging Against a Bear Market with Inverse ETFs
There are many inverse stock ETFs available to reduce some market risk in your portfolio. We can categorize them by the market size of their benchmark index (large cap, small, cap, etc) or by specific sector (financials, technology, energy, etc).
The largest companies by market capitalization are in the Dow Jones Industrial Average. It has giants such as Apple, Exxon and Wal-Mart. There are pros and cons with using the inverse ETF on the Dow Jones, the ‘Short Dow 30’ (‘DOG’) inverse ETF. It is a very liquid fund with over $277 million in assets and does have. Since the index is price weighted while most indexes are market cap weighted, you’re not getting a true representation of the broader markets and thus, your portfolio.
A better alternative is hedging stocks with the ‘Short S&P 500’ (SH), an inverse ETF which better represents the broader stock market. It is market cap-weighted and has more financial products tied to its performance than any other. It is the largest inverse stock ETF at over $1.6 billion in assets under management and it trades millions of shares per day. It is a single inverse ETF (-1X) and aims to return the inverse of the Standard & Poor’s 500 Index on a daily basis.
S&P 500 index comprises 500 of the largest and well-known stocks listed in the U.S. and the largest sector weightings are technology, financials, health care and industrials. But no one sector really dominates the index, making it a good proxy for the market and for a (seemingly) well-diversified portfolio. And even though the companies are all U.S. based approximately 1/3 of earnings come from outside the U.S. This ratio of 70/30% is basically the way many portfolios are constructed (2/3 domestic equity and 1/3 international) so this should hedge a slowdown in other parts of the world (and your portfolio also). Globalization of the last decade or so has made so many international markets interdependent that they’re starting to correlate more than ever before.
http://money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/2015/03/04/the-mutual-fund-fees-we-dont-talk-about
