Hedging Your Bets

By Aaron Levitt | April 15, 2010 AAA

The Dow (NYSE:DIA) broke the all-important psychological 11,000 level this week and the S&P (NYSE:IVV) is flirting with 1,200. The economy seems to moving in a positive direction as higher consumer confidence and higher corporate earnings are becoming the norm. However, the picture isn't necessarily all that rosy. Sovereign debt worries from Greece, Spain and Dubai still plague the headlines. Massive looming federal and state budget deficits will result in higher taxes. Even with the recent job creation, unemployment is still very high and the number of underemployed is growing. The real question now for investors after the recent run-up in asset prices is what the future will bring.

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We All Could Use a Financial Hedge
Over the long term, stocks have typically been the best place to put your money. But after the recent financial beating, many investors are finding little to no comfort in historical trends. Older investors planning on retiring soon don't have much time to recover if asset prices plunge another 55% as they during the height of the crisis. Younger investors are plain spooked by the recent events and many have altered their investing styles. There are real worries out there. However, just as a homeowner who lives in a flood plain takes out insurance against such an event, many investors would sleep better at night if they build hedges into their portfolios.

If there is one lesson to be had from the financial debacle, it's that in the time of real crisis almost all asset classes seemed to fail. Simple diversification in a complex global economy may not be enough to save investors from heavy losses. However, with the recent exchanged-traded products boom, retail investors have been giving some sophisticated tools to help protect their portfolios from large market downturns.

Strategies for Insurance
Options strategies have often been the realm of day traders, high net-worth individuals and institutions, and are often ignored by the retail investor space. Today, however, using ETFs, a simple covered call or buy-write approach, is attainable for any sized portfolio. A buy-write at its simplest form is where an investor buys a basket of stocks tied to an index and writes call options that cover the stock position. The income generated from the option helps cushion sideways and downward movements in the index or stock price.

The PowerShares S&P 500 Buy-Write (NYSE:PBP) and the PowerShares NASDAQ-100 Buy-Write (Nasdaq:PQBW) offer investors a way to hedge their bets against two of the larger broad-based stock indexes. Both funds charge 0.75% in expenses and will underperform the indexes in bull market mode, but will help limit losses if there is another major downturn. Investors wanting to hedge a global portfolio can turn to the Eaton Vance Global Buy-Write Opportunities Fund (NYSE:ETW) which holds about half of its stock allocation outside the United States.

Inverse ETFs allow investors to bet against (short) various market indexes without technically having to short a financial asset. They come in variety of flavors, tracking various indexes and degrees of leverage. Day traders aside, for most investors the broad based non-leverage variety, are the best for hedging a portfolio.

The ProShares Short S&P 500 (NYSE:SH) and the ProShares Short Dow 30 (NYSE:DOG) are ways to play the big indexes' downfall. These funds aren't perfect; investors should understand that these funds reset daily, which over long periods can result in tracking errors.

The Chicago Board Options Exchange's Market Volatility Index (VIX) is essentially, the equity market's key gauge for fear and it has been dropping as the economy has been in rebound mode. A direct investment in the VIX is not possible; investors can participate through futures contracts on the index.

Playing the markets "fear" is similar to shorting equities. Investments in the iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX) which follows the two closest monthly contracts and the iPath S&P 500 VIX Mid-Term Futures ETN (NYSE:VXZ), which extends its contracts longer, are direct plays on this sentiment.

The Bottom Line
While the market has been on a tear the past few months, it's easy to throw caution to the wind and forget about portfolio insurance. The exchange-traded products boom has made it possible for regular retail investors to add sophisticated portfolio hedges quite easily. The global situation is getting better, but there is still much uncertainty in the economy. Prudent investors would be wise to add some indemnity to their portfolios.

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