So far, 2012 is shaping up to be a pretty good year for portfolios. The so-called risk trade is back on and once again, investors have been piling into stocks, commodities and a variety of other chancy asset classes. The broad markets have cleared some important psychological benchmarks and the overall global economic situation seems to be getting better. However, given all the recent bullishness, some analysts predict that a pullback might be in order. Any bad news from Greece or poor economic data could undermine the recent rally. To that end, investors may want consider adding a hedge to their portfolios.
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Starting to Get Frothy
After a flat 2011, stocks have surged as the global economic picture as turned rosier over the last few months. For the first time since 2008, the iShares S&P 500 Index (ARCA:IVV) recently surpassed the all important 1,400 barrier. Likewise, the Dow Jones Industrial Average is flirting with its 13,000 mark. Recent economic data from the housing, labor and consumer sectors have all turned positive. While all of this is certainly good news, some analysts have begun to question the near-term prospects for the market.
After all, there are still plenty of risks facing investors today. First, much of the market's rally over the last few years has been caused by the flood of cheap money due to various governmental quantitative easing programs. As interest rates have been kept at historic lows, investors have had no choice but to move into other assets. However, given the recent good economic news, many analysts predict that the Federal Reserve will need to raise interest rates faster than anticipated. That could spell doom for riskier stocks. Secondly, there is still plenty of economic risk coming from Europe. The European Central Bank's latest bailout only serves to "kick the can" further down the road. In addition, China's potential slowdown could have adverse effects as well.
Given the risks and stocks' new highs, investors may want to think about hedging their recent gains. The recent exchanged-traded products boom has allowed regular retail investors access to sophisticated tools to help protect their portfolios from large market downturns. No one ever wants to experience a disaster, but we buy insurance just in case those scenarios play out. By adding one or more of these portfolio hedges, investors can rest more soundly if there is a major correction. For related reading, see A beginner's Guide To Hedging.
Perhaps the easiest way to stem losses in a falling market is to be short the market. With over $2 billion in assets, the ProShares UltraShort S&P500 (ARCA:SDS) is one the largest and most liquid ways to add downward protection to a portfolio. The fund is designed to provide a negative two times the performance of the S&P 500. Likewise, the Direxion Daily Total Market Bear Shares provide short exposure to 2,500 companies in the United States. Nonetheless, these funds aren't perfect; investors should understand that these funds reset daily, which over long periods can result in tracking errors.
Acting as hedges against inflation and uncertainty, precious metals like gold, platinum and silver should be a part of every investors portfolio. The ETFS Physical PM Basket Shares (ARCA:GLTR) allows investors to own a basket of these metals plus palladium. For a cheap 0.6% in expenses, investors can have the peace of mind by owning gold as well as playing the growing industrial demand for silver and palladium. Exchange-traded funds also offers its Physical Swiss Gold Shares (ARCA:SGOL) for those investors wanting to just play gold's continued luster.
Sell Some Options
Finally, option income and dividends can provide some cushion during falling markets. By writing covered calls on an index or stock position, the income generated helps stem losses. Both the PowerShares S&P 500 BuyWrite (ARCA:PBP) and iPath CBOE S&P 500 BuyWrite Index ETN (ARCA:BWV) take the complexity out of writing the physical options. Similarly, the PowerShares S&P 500 Low Volatility ETF (ARCA:SPLV) bets on a basket of stocks within the S&P that should move "less" (up or down) than the index. This should help mitigate any wide market moves.
The Bottom Line
After a flat 2011, the New Year has brought some pretty good gains to the stock market. A variety of economic data is pointing upwards and over sentiment is bullish. However, there are some potential pitfalls facing investors. To that end, it might be time for a hedge. The previous picks, along with the iPath S&P 500 VIX Short-Term Futures ETN (ARCA:VXX) make ideal selections for hedging a portfolio. For more, see Hedging With ETFs: A Cost-Effective Alternative.
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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.