Is Your Portfolio Fully Hedged?

by Wes Bridel on May 23, 2011

in Stewardship

The Fully Hedged Portfolio

We’ve been running a series on different types of portfolios for different types of investors.  Today, we look at a hedged portfolio to see the benefits of not being dependent on the whims of the market emotions.

Alma is tired of losing money….and she has no idea which direction the market is going.  She knows she needs to grow her money, but cannot for the life of her figure out how best to position it to do that.  She can’t handle a lot of risk.  Yet, from everything she’s read about possible economic scenarios in this current market, there doesn’t seem to be any option without risk.  In the old days, you could hold bonds or CD’s and collect interest on those, but what if inflation goes through the roof and your so called “safe” savings vehicles end up being worth very little in real terms?

She’s sure about what to do with the majority of her assets.  The main positions she holds with her liquid holdings are Mutual Whole Life insurance, gold, and silver.  Alma knows with a foundation of those three things, she will come out of any uncertain economic environment way better than most.

But she also feels like she needs to have some money in the markets.  After researching all of her alternatives, Alma decides to create “The Fully Hedged Portfolio”.

The idea is simple.  She wants to have exposure to the upside in any possible market move while reducing her downside exposure as much as possible. She wants to hire the best possible managers in areas of their particular expertise and combine the holdings that each manages for her into a portfolio that either:

1)      Hedges one position against another, OR

2)      Is itself a hedged position, OR

3)      Is a completely non-equity-correlated asset.

By doing this, she is relying on the expertise of her managers to eke out a return above the noise of the overall market.

Let’s look at the ways that she does this….

30%  in Conservative Stocks (Ex. High Dividend, Deep Value, Covered Call Writing Portfolios)

30%  in a Short Focused Fund

20% in various Hedge Fund Strategy ETF’s (non-market correlated)

20% in a Momentum Fund shiting amongst Global Resource Sectors/Companies

You’ll notice that she has 30% of her brokerage portfolio in three long equity positions.  Directly opposing these in the exact same percentage is a bearish, or short, fund.  With these combinations of positions, there is little market risk of the portfolio going up or down. The risk is in the hands of the managers/allocations themselves.  Ideally, the short fund will increase more in down markets then the long funds will lose.  And hopefully, she has chosen just the right long funds to outperform in the coming market environments far more than the short fund falls in these same upswings.  Thus her return reflects the outperformance of her managers far more than it does the direction of the market in general.

The dividend fund that she has chosen focuses on high paying divided companies that she feels will perform better in choppy markets.  The value fund is managed by one of the most famous value investor of all time who seems to relish the opportunity to profit from difficult markets.  Finally, the Buy/Write Portfolio owns the S&P 500 while simultaneously selling covered calls to maximize income in times of choppy markets.  Others might choose to go with more high flying equities if they are going to be hedged, but these are the holdings that seems most sensible to Alma.

Hedging “the right” Individual Securities works best

Another important technique that Alma uses is the buying and shorting of individual securities.  This is the most accurate and efficient way for someone who understands balance sheets to run a hedged portfolio.  By choosing to buy stocks which generate tremendous and sustainable free cash flow from stable businesses at attractive valuations, Alma knows that she can confidently hold these businesses for the long haul even if in the short term the stock price drops considerably.  Her portfolio is hedged and protected by shorting individual securities which are hanging onto life by their fingernails.  She shorts these businesses which for no rational reason, the market continues to value highly even though they are losing money and have severe debt problems.

For example, a few years ago, the market was still valuing General Motors fairly strongly because many people felt like GM represented America itself and could never fail.  The reality though, if you looked into their financial performance, was that they had lost money 19 out of the 20 years prior to the government nationalizing them.  Looking back, it’s easy to see that this company should have been shorted.  Some people did take the time to look at the facts, throw out the emotion and sell short this firm.

Hedge Type Funds

The final component of Alma’s strategy is to use funds that are themselves hedged in some way.  She uses a tactical fund which rotates out of underperforming sectors and into better performing sectors around the world under the philosophy that there’s always a bull market somewhere.

The relative value fund that she uses is typically market neutral by placing long and short bets on ETF’s around the world.  Thus she has professional management doing something similar to what she herself is doing in other parts of the portfolio.

Alma uses a multi-hedge fund strategy fund to track the results of hedge funds which normally take millions to invest in, and she does this without the huge fees of the typical hedge fund.  Because this involves strategies that are totally outside of the normal equity market universe, the returns are totally uncorrelated to those of the rest of the market.

And finally, because Alma believes in the worldwide commodity boom story, she uses a fund which rotates into the hottest commodity sectors while also holding a short (hedge) position on equity markets in general.

Alma feels like she has hedged as much market risk as possible out of her portfolio while still being able to participate and ideally achieve a superior return to the overall market by employing careful risk management.

This is Part 7 in a series on Real Life Examples of Portfolio Management.  You can read the previous posts at: Pt 1, Pt 2, Pt 3, Pt 4, & Pt 5, & Pt 6.  We just finished a series on the different types of investors which you might want to check out at the following links:  Pt 1, Pt 2, Pt 3, Pt 4, Pt 5, & Pt 6.

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