The traditional ways to hedge against stock risk often fail to meet the protection and/or profit needs of investors. Multi-asset stock hedging seeks to account for those challenges.
Going to cash, shorting, using inverse ETFs—there are a number of drawbacks associated with the conventional methods. It is worth reviewing those shortcomings in the process of addressing the advantages of multi-asset stock hedging.
Why not use money market funds or other cash equivalents alone? In two words… the Fed.
Due in large part to ultra-low rate policies by the U.S. Federal Reserve, cash equivalents only outpaced inflation in four of the last 14 years. This is wholly different than the two decades before 2000—the 80s and 90s—where cash equivalents outpaced inflation in each of the 20 years. In essence, the Fed has penalized responsible savers for not wanting—or needing—to take on more risk.
In fact, since 2000, U.S. treasury bills have realized a paltry 1.39% annualized return. The problem is particularly glaring when you factor in the the 2.15% rate of inflation in the same period. It follows that the inflation-adjusted total return in this time span for “risk-free” investing is -12.23%. That’s right. You lost more than 12 percent in purchasing power for responsibly socking your money away in the safest place possible. Thanks Mr. Fed!
Granted, watching your dollar value remain steady when markets are crumbling around you is comforting, regardless of a small loss in purchasing power. It is the reason that you may hear people in troubled times say, “cash is king.”
On the flip side, there are a number of side effects of remaining in cash for too long. Investors often feel frozen like hippos in headlights, searching for the courage to “get back in.” They rarely do. Investors who run for the exits in fear are the same ones who are exceptionally late to attend the screening of the new movie. Additionally, if your cash is represented by a money market alone, it ignores the benefits of several global currencies that have historically performed well when stocks have not. The probability of appreciation in those currencies is often worthy of an allocation.
Why not use inverse ETFs that move in the opposite direction of stocks? Inverse ETFs are daily compounding tools for traders, not hold-n-hope assets for investors.
Inverse ETFs may be the most misunderstood investment vehicles available today. Why? The stated objective is to capture the inverse return of the fund’s benchmark (target) for a single day. That last part has been bolded for good reason. Many investors assume that an inverse ETF will return the opposite of what the benchmark returns over any period of time, whether it be a day, a week, a month or a year. Unfortunately, this assumption reflects the average investor’s misunderstanding of math and compounding. And that assumption, or lack of understanding, can be exceptionally costly.
For example, let’s assume that you had been earning exceptional returns in the mid-2000s through the ownership of real estate investment trusts (REITs). Heading into 2008, however, you accurately assessed the landscape to determine that the real estate sector was in trouble. On the one hand, selling your REIT funds would create a heavy levy in the form of capital gains taxes. Yet, holding them “willy-nilly” might mean the erosion of the gains you spent years accumulating.
After some research, you decided that the smartest move might be to hedge against a severe decline in real estate-related assets on market-based exchanges. One promising way to accomplish the goal? Purchase the ProShares UltraShort Real Estate ETF (SRS)—an inverse fund that pursued a daily result that is -2x (negative 2 times) the return of the Dow Jones U.S. Real Estate Index. In theory, if the Dow Jones U.S. Real Estate Index drops 1% in a day, your fund gains 2%.
Sure enough, 2008 was one of the worst years for real estate and the Dow Jones U.S. Real Estate Index fell by nearly 50%. Your forecast at the start of the year was a grand slam. According to your “back-of-the-napkin” calculations, your investment in SRS should have roughly doubled in value—up 100% for the year!
Sadly, this is not the way that daily compounding works. Despite the benchmark dropping nearly 50% in 2008, the ProShares UltraShort Real Estate ETF (SRS) actually lost 55% in 2008. Yes, you read that correctly. The ultra-short, two-beta inverse asset fell deeper than the Dow Jones U.S. Real Estate Index itself. Instead of effectively hedging your exposure to you REIT funds, your purchase of SRS was the equivalent of dousing your portfolio in kerosene.
So what happened? To find out, one needs to revisit the inverse ETF’s stated objective. (“The fund seeks to capture 2x the inverse return of the fund’s benchmark, the Dow Jones U.S. Real Estate Index, for a single day.”) Once you grasp the unique nature of daily compounding—how the process resets each trading session—you become more cognizant how daily compounding may bear zero resemblance to weekly, monthly or annual compounding. This is especially true during periods of extraordinary volatility like 2008—the exact kind of environment that one often requires an effective hedge against equity losses. In brief, inverse ETFs may work best as exceptionally short-term hedges and as quick profit trading tools, but they are not particularly useful for lengthier corrections or more pronounced bears.
Why not “short” investments or use options? The costs, risks, complexities and “timing” may be prohibitive features.
For one thing, problems often arise when one shoots for the moon on a gamble against stocks. The strategy does not simply involve the risk of accurately timing a market event… it typically requires an investor to become an extremely active trader with predictive powers. (Those who have made successful bets on one occasion often neglect to share how wrong they were on another!)
Secondly, there are unique emotional tolls that shorting brings to the hedging equation. If you think it’s bad to be wrong when you purchase a stock, try being wrong when you sell short a stock. The reality is such that when you are wrong, you are wrong twice as hard. Not only do you lose money on the “short” side, you also lose the money that would have been made on the “long” side. Many investors quickly learn that selling short to hedge against stock risk can be an exercise in atrocious humiliation. Specifically, if you don’t have an exit strategy for being on the wrong side of an ever-appreciating stock market, the destruction to your portfolio could be monstrous.
Third, “shorting” strategies carry additional costs. You will pay interest on the margin account that you must maintain to engage in the activity. In fact, it is very similar to keeping an unpaid balance on a credit card—the longer you carry the margin account balance, the more time the interest withers away the dollars meant for hedging against risk.
Options are yet another ball of wax with unique expenses and dangers. You pay an up-front premium to buy an option. Each contract that you buy endures an additional premium. “Put” options can get particularly expensive when establishing multiple portfolio positions, not to mention that they have limited lifespans.
Why Multi-Asset Stock Hedging? Multiple asset classes can provide the diversification that reduces the risk of relying solely on a single asset type.
For example, many regard U.S. treasury bonds as a port of call when stocks are suffering. Yet should those treasuries be shorter or longer in duration? Short duration treasuries have been less effective on a historical basis. Meanwhile, some funds or individual issues may have poor liquidity. Additionally, U.S. treasury bonds alone may limit one’s ability to benefit from the sovereign debt of other nations—those debt instruments with notable promise during U.S. stock downturns.
Perhaps ironically, if you search the worldwide web for hedging against a downside slide in stocks, you will only come across the same old lyrics from the same old songs. “Go short” or “Buy bonds” or “Cash is king.” Heck, you may even be advised to ignore risks altogether, since most financial advisers carelessly fall back on a “buy-n-hold-n-hope” approach. In contrast, multi-asset stock hedging offers exposure to different currencies, unique debt instruments and a safer haven commodity in gold. Diversification reduces the risk that any one of the promising asset types is unable to profit or protect as anticipated.
Specifically, what are the non-stock assets that have shown appreciation and/or preservation of capital potential in stock downtrends? The type of bonds that tend to hold up and/or grow the best are Treasury Inflation-Protected Securities (TIPS), zero-coupon treasuries, longer-term treasuries, Japanese Government Bonds (JGBs), German bunds and municipal bonds. Capital flight also makes its way into currencies that are perceived to be safer havens, including the U.S. dollar, the Japanese yen, and the Swiss franc. Granted, the yen may not seem like a safer haven, until one realizes the power of a rapidly unwinding carry trade. Finally, gold is the one precious metal that has demonstrated effectiveness and consistency as a hedge in bearish stock downtrends.
Pacific Park Financial, Inc. employed all of these asset classes to develop the first and only multi-asset stock hedge index with FTSE (pronounced FOOT-see), the global leader in indexing. The FTSE Custom Multi-Asset Stock Hedge Index went live on 11/19/2014 and possesses daily data dating back to 6/30/2011.
The FTSE Custom Multi-Asset Stock Hedge Index tracks ETFs/ETNs that represent each of the above-mentioned asset categories. It provides investors with an alternative to the higher-risk nature of shorting as well as the limited scope of single-asset stock hedging. The index also provides a meaningful performance benchmark for those investors who choose to invest in the types of assets that have, historically speaking, performed well during severe stock market declines.