Hedge without using a hedge fund

Many market strategists and experts believe that in spite of the recent market rally, the fallout from the credit crisis has not ended. They often suggest that investors consider capital preservation strategies and to find hedge funds that actually hedge.

While true hedge funds can be useful, they do have limitations.

First, hedge funds are generally designed as a product that, when combined with a broader portfolio, offer diversification. These offerings, however, are usually neither scalable nor unique to hedge an individual’s specific portfolio.

Other shortcomings can include lack of transparency and liquidity, high expenses and entry costs. An investor is usually unaware of the exact holdings of a hedge fund at any point in time. Thus, one cannot be sure what risk is actually being offset. Plus, it is not uncommon for hedge funds to be redeemable quarterly or monthly. As well, hedge funds are not cheap and often come with performance fees. Further, buying a hedge fund usually requires one to come up with cash, which for many might mean liquidating existing positions – perhaps disturbing cash flow and triggering capital gains.

There are, however ways to hedge your portfolio without using a hedge fund.

1. Index Futures: If the markets are in a large free fall, a good method of protection can be to sell futures index contracts such as the mini S&P 500 (ES-FT1,174.009.500.82%). Unlike options, there is no time premium, so the cost is minimal. Further, they are usually very liquid, and contracts such as the mini S&P trade almost 24 hours a day through the week and Sunday evenings after 6 p.m. You can also try to build the exact offset to your portfolio by combining different futures contracts. If constructed properly, the net portfolio value should remain static regardless of market conditions.

2. Put Options: When there is little volatility in the market and not a lot of fear, buying put options on exchange traded funds (ETFs) on indexes such as the S&P or the TSX might be a good idea. This way, you can have the protection in place if markets fall, but still participate if markets rise. One way to gauge the overall level of fear (and the price of put options) is through the level of the CBOE Volatility Index (VIX-I18.93-0.03-0.16%). In a nutshell, the VIX reflects the price option traders pay to protect positions through put options. The higher the value of the VIX, the more expensive the put options will be.

3. Selling Covered Calls: When one is bearish in the short term but not longer term, selling covered calls on individual positions can be a good alternative. This way the investor can harvest some income from the portfolio to offer some downside protection. This income is generally taxed as capital gains. The best time to do this is when the stocks in question are viewed positively, as the premiums will be high.

4. Shorting ETFs or buying inverse ETFs: If an individual has a smaller portfolio and requires greater scalability than futures contracts allow, shorting instruments like ETFs might be a good way to gain protection. Buying inverse ETFs can also work but require more capital. In registered accounts where shorting is not allowed, inverse ETFs may be a good option. One should be mindful, however that ETFs can sometimes experience tracking error.

Benefits

The benefits of these strategies are numerous. First, unlike a hedge fund they do not require a lot of capital to achieve the objective – to hedge. Second, since they are used in tandem with your existing portfolio, capital gains need not be triggered and cash flow unaltered. Third, one can scale into these strategies slowly over time. Fourth, costs can be low.

But most importantly, when an investor uses these methods, they can achieve transparency and better assess the degree of risk in their portfolio – a comforting thought in these uncertain times.

While these strategies can be very helpful, investors should carefully consider the advice of a qualified professional to assess which, if any, are suitable for them.

Gregory Newman is a senior wealth adviser at the Newman Group, ScotiaMcLeod, a division of Scotia Capital Inc.