4 Methods To Hedge An Equity Portfolio (BND, DBC, VEU, VNQ, VTI, SH, SPY, SHY)

Market volatility and drawdowns remind us of the role “hedging” can have in portfolios.  Hedging in its simplest form is purchasing securities in order to reduce portfolio risk. The purchased securities are intended to have negative correlation to the remainder of the portfolio in order to help offset any potential losses in the portfolio.

Holding uncorrelated assets, such as stocks and bonds, are one of the most popular methods for reducing portfolio risk since historically stocks and bonds are relatively uncorrelated.  There are other methods methods for hedging downside risk and this article explores four methods for hedging long equity positions.

Moving Average
One of the more popular methods for minimizing downside risk and one I track frequently on Scott’s Investments is to exit long positions when they fall below a long-term moving average.  This may not technically be a hedge, since the entire position is exited.  However, as Faber showed in The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets, it is an effective method for reducing volatility and risk in a portfolio.

There are other options for investors who hold individual equity positions and hedge. For example, say you hold a position in two stocks, ABC and XYZ and wish to hold both stocks for the long-term.  However, the overall equity market has you a bit nervous and has recently begun to struggle, showing signs of weakness. One option would be to short the overall equity market and one of the simplest ways to do so would be via a 1x inverse ETF such as SH (Proshares Short S&P 500), which seeks daily investment results that correspond to the inverse of the S&P 500 Index.  You could also use an inverse small cap, international, sector, etc. ETF depending on the long positions you currently hold.

I most recently back-tested an example of this moving average hedge system in March 2010.  I used AlphaClone to generate my individual stock holdings.  I then shorted the S&P 500 in an equal amount (100% hedged) only when the S&P 500 closed below its 10 month simple moving average.  The system did not have a down year since 2000.  While much of the performance can be attributed to AlphaClone‘s ability to find stocks with hedge fund support, the hedge did its job in reducing volatility and drawdowns:

          Clone   S&P 500

CAGR 23.84% -0.53%
Vol 15.49% 16.02%
Max DD -17.50% -50.95%
                    Clone                 SP500                       +/-
2000 29.68% -8.2% 37.88
2001 20.18% -11.9% 32.08
2002 2.07% -22.1% 24.17
2003 38.10% 28.7% 9.4
2004 31.81% 10.9% 20.91
2005 18.44% 4.9% 13.54
2006 20.39% 15.8% 4.59
2007 14.26% 5.5% 8.76
2008 12.25% -37.0% 49.25
2009 41.30% 26.5% 14.8
2010 4.63% 3.1% 1.53

Relative Strength

Using ETF Replay, we can compare the relative strength and volatility of ETFs and backtest various ETF strategies.

Assume we hold a portfolio of 5 ETFs – bonds (NYSE:BND), commodities (NYSE:DBC), international equities (NYSE:VEU), REITs (NYSE:VNQ), US equities (NYSE:VTI), which represent 5 major asset classes.  A buy and hold portfolio since 2008 had 22.4% volatility and a -46.28% drawdown  (despite being allocated across 5 seemingly diverse asset classes) and, frankly, disappointing results (results from ETF Replay include dividends):

I created a portfolio of long S&P 500 (NYSE:SPY), short S&P 500 (NYSE:SH), and short-term treasuries (NYSE:SHY), used as a close proxy for cash).  I went long whichever of the three had the highest combined ranking as determined by the highest relative strength over the past 3 months and 20 days, and lowest volatility over the past 20 days.  The system rebalanced semi-monthly (for those looking to limit turnover the monthly re-balance returns were slightly lower but similar to semi-monthly), produced the following results. While volatility was  high, which is to be expected when only holding one position, returns far outperformed a long only strategy (NYSE:SPY), which was also to be expected given the market volatility of 2008:

How could one use this information to hedge? If an investor held 50% of a portfolio in the 5 ETF portfolio referenced above and allocated the other 50% to the SPY,SH,SHY strategy, we reduce volatility and drawdowns during one of the most volatile periods in recent history, and still produced solid returns. This is mainly owed to positions in SH which hedge the positions in the 5 ETF portfolio that were highly correlated in 2008.  I used a 50% allocation to both strategies for simplicity and not as a recommended allocation:

Market Conditions

A third hedging strategy is to based long/short positions on overall market conditions.  There are a myriad number of ways to gauge “market conditions” and how one hedges these “conditions” depends on your time-frame and current portfolio.  However, assume we hold a portfolio of US equities or US equity ETFs and wish to hedge them during “unfavorable” market conditions.

I am a big fan of the analysis at dshort.com, and pay close attention to the P/E Ratio Market Valuation updates. Ideally, we could employ a hedge when the market is “overvalued”. However, markets can stay over and undervalued for lengthy periods of time, sometimes years.  Thus, basing  a hedge on relative long-term market valuation alone can be a costly and lengthy experiment.

Stockscreen123 has devised a timing system suitable for longer term investors that has historically still reacted quickly enough to serve as a hedge during unfavorable market conditions.  The system uses 2 factors to determine “market conditions”:

 It assumes conditions are favorable for equity investing if EPS estimates are rising and if valuations are reasonable.

  1. The estimates test is whether the 5-week moving average of the aggregate of the consensus current-year estimates for S&P 500 companies is above the 21-week moving average.
  1. The valuation test is based upon risk premium, specifically, whether the S&P 500 risk premium (earnings yield minus 10-year treasury yield) is above 1%

When conditions are “favorable”, one would be long equities (hold SPY) and during unfavorable conditions, short equities (hold SH).  Re-balancing every 4 weeks for 5 years results in the following equity curve (red line)  compared to the S&P 500 (blue line):

During periods of high volatility and market drawdowns, this system performed well, moving inversely to the S&P 500, and could have served as a functional tool for determining when to hedge equity (or other) positions.

The current signal indicates favorable market conditions and a position in SPY.

Technical Analysis

Technical analysis can also serve as a method for determining when to hedge long positions. If an investor is comfortable and skilled enough in conducting his or her technical analysis, then during periods of high uncertainty or unfavorable technical setups, either in a market index or in an individual position, a hedge may be appropriate. The hedge could again be a short position in an index ETF or could be an options position on an individual holding.

Technical analysis is a broad subject with many tentacles so a comprehensive review is not possible.  However, as a general rule, support and resistance lines and trend lines are good starting points for analyzing technical setups and I wrote about one such setup last week with Chris Vermeulen giving us an example in this  chart of what he saw headed into the week of the 14th (chart courtesy of The Gold and Oil Guy):

This article should not be considered a complete list of hedging methods as there are myriad others ways to hedge a portfolio (options being a popular method which was not discussed here). Hopefully it served as a starting point for further considerations on how and when to hedge equity positions and your portfolio as a whole. 

Returns discussed excluded commissions and taxes.

Written By Scott’s Investments   Disclosure: No positions

Scott’s Investments focuses on several different ETF portfolio strategies ranging from Basic, Individual, Country, US Sector, and Global Sector ETF portfolios.

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