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I was recently asked by a reader (thanks Edwin) about my take on using a hedging strategy in a dividend investing portfolio. Although I have never done any true hedging (other than covered calls) in my dividend growth portfolio, it has been a huge topic of discussion from many financial pundits as a way to help limit the downside with a sliding portfolio. I did some research on it and wanted to provide a quick overview here, and provide my take on it.[ad#tdg-embedded]
The intention of hedging is to offset the downside risk in a portfolio through the purchase of an asset that will reward you if your portfolio goes the other way than you intended. This definition from Investopedia really sums it up best:
The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesn’t prevent a negative event from happening, but if it does happen and you’re properly hedged, the impact of the event is reduced.
Edwin’s suggestion was that an investor could hold 75% of their portfolio in dividend growth stocks and then purchase an exchange-traded fund that shorts the market using 3x leverage. The intention is that when the market tanks, you reap the gains three-fold. There are other types of hedging, such as using puts or covered calls to limit your downside. As I was doing some research on the topic, I could not find any definitive evidence that hedging was a good or bad strategy. I had to make my own call, and came up with the following two reasons that hedging using leveraged short ETFs are not for me:
1. I am a long-term Investor
My viewpoint is that over long periods of time (10+ or even more years) the market goes up more than it goes down. As such, I see portfolio hedging as a short-term strategy that simply helps to manage an investors emotional reactions when the market is going down. I have said it before, unless you truly understand your risk profile then you are prone to make rash portfolio decisions. If you are really comfortable with your asset allocation, then you should let it do its work over the long term.
2. Hedging can be Expensive
Buying portfolio insurance can be expensive. For example, the ProSharesUltraShort Russell 2000 (TWM) has an expense ratio of 0.95%. If the market is going up and this fund is working against you, then that additional MER will continue to erode the value of your portfolio. As a long-term investor (see above), my pontification is that the market will rise over long periods of time so why pay these additional fees.
This being said, I have been know to hedge using covered calls from time to time if the numbers look good. I therefore cannot say that I will never hedge, I just doubt I will hedge using a shorting strategy. The costs and the short-term focus simply go against my portfolio strategy.
TDG,
The only thing that a dividend investor should be hedging is their currency exposure in the case that they own foreign stocks which pay dividends in a different currency.
With hindsight selling short an ETF or Index Future against your portfolio in 2008 would have worked wonders. But over the long run the performance would be worse than a simple bond investment. Some pundits were urging subscribers to sell short or hedge themselves when Dow was at 8300. This leads me to my next point – what if you “hedged” at the bottom of the market? You would have essentially locked in the maximum amounts of losses.
Now you could also buy puts against your portfolio, which could be costly in the long run.
I think it’s important to point out that those leveraged ETF products are targeting DAILY leveraged exposure. So your positive days (up or down as the case may be) must be sufficiently greater than your negative days to realize returns over longer holding periods. They’re better used for short term betting than long term hedging.
Great post!
Essentially, I think you summed up the reason a lot of more complex portfolio management strategies are “not for” the common investor. Be a long term investor, and you have the benefit of the time value of money and investing. If your investment horizons are shorter, maybe focus on limiting your exposure to risk (bonds, etc) instead of hedging against it.
Hi,
TDG, Thanks for addressing the subject. Just wanted to clarify, I understand those ETF products target daily leveraged returns, so that in the longer term they will never be perfectly 2x or 3x the inverse of the broader market. However, the brokerage I use is FolioInvesting, which charges a flat per month fee for unlimited trades, so I’d essentially be able to rebalance my portfolio on a relatively frequent basis (daily/weekly/monthly, etc.) without incremental costs. This is where my idea initially came from.
Anyways, thanks for the post. Your thoughts and opinions are much appreciated.
Thomas hits the nail on the head. You can’t diversify using this product because of the way it levers itself daily.
Manshu: What if you are able to rebalance your portfolio daily? (Assume no incremental commission/fees)
Edwin: Thanks for bringing up this great point. In fact – theoretically – you can do that – provided the markets are not so volatile, that a substantial part of your initial investment is wiped out in a day or two.
Second thing is – I don’t think a person who is not glued to his brokerage account will be able to do this.
Third thing is – personally – I think an – out of the money put option – for a far off date on the main index will give you the same safety, without so much exposure.
What do you think?
Also, I was so interested in the subject, that I wrote about it myself:
http://www.onemint.com/2009/01/15/do-not-use-a-leveraged-etf-for-hedging/
Thanks to everyone for the excellent comments on this. Manshu I think your post is very interesting and really highlights the problems with this – you go in the whole quickly and it takes larger and larger market moves to get out of the hole.
In terms of the comments of rebalancing the portfolio daily – the fees and frictional costs would rip your face off.
Thanks again.