Funds and ETF's
How to hedge your portfolio like the pros

By Jason Chow
Globe Investor Magazine Online, April 16, 2008

With all the market volatility this year, it’s hardly a surprise that investors have sought refuge in the so-called bear ETFs – funds that profit when the market go down.

These bear exchange-traded funds can be confusing and intimidating at first, but if used the right way, they can integral to a portfolio once you learn some basic concepts about hedging. Sound too complicated? Don’t be scared. With this new breed of ETFs, you too can easily employ the techniques of Wall Street wizards in your own portfolio.

But first, some basics about the funds.

What are bear and bull ETFS?

In Canada, Horizons BetaPro are the sole managers that offer ETFs of this kind and they have seen their business grow quickly since it began in January 2007. In the past 14 months, money invested in its Horizons BetaPro S&P/TSX 60 Bear Fund (HXD-TSX) has grown from zero to more than $300-million. The fund plays opposite the index: it moves inversely to the action of what the S&P/TSX 60 index does and at a twofold rate. For example, if the main index falls 1 per cent on the day, HXD rises about 2 per cent.

Horizons also runs its so-called Bull Funds that track the index but at twice the magnitude. The Horizons BetaPro S&P/TSX 60 Bull Fund (HXU-TSX) rises about 2 per cent when the main S&P/TSX 60 index goes up only 1 per cent.

The HXD fund is the most popular of Horizons’ offerings, but the company also offers bear funds that track oil, gold, grains and stocks in the gold and financial sectors.

In the United States, there are funds that track U.S. indexes in a similar way organized by Pro Shares and Deutsche Bank. They too have also gained in popularity during recent months – a natural response considering that the S&P 500 is off 9 per cent this year. Some of the more popular ones include the Ultra ProShres QQQ (QID/AMEX), which is a bear fund that tracks the Nasdaq composite index, and the Deutsche Bank Gold Double Short ETN (DZZ/NYSE) which had a 14-per-cent rise in just two days last month when gold prices dropped steeply.

How do I use them? And what is a hedge?

Hedge funds have made “hedging” into a sexy term, promising huge returns using convoluted mathematical models that would maximize market inefficiencies. But don’t let them fool you: A hedge simply means a way to reduce risk in an investment.

That’s all.
So with that in mind, here’s an outline of a few basic hedging strategies that involve bear and bull funds that an average investor can comprehend.

1. The classic smoothing hedge.

Like many investors, you probably can’t stomach topsy-turvy markets, watching the value of your portfolio dip and turn like a roller coaster. But at the same time, you know that over the long term, stocks are the way to go and you know it’s best to stay invested for a while.

There’s a way to appease both parts of your investment psyche. Let’s say you have $100,000 in the iShares Canadian S&P/TSX 60 Index Fund (XIU-TSX), which tracks the namesake index. If the index goes up 10 per cent, your investment is worth $110,000 though if it goes down 10 per cent, it dips to $90,000. Now to smooth out the volatility, you make a simple hedge by investing part of your money in the HXD bear fund. Since it follows the inverse of the index, you can make up some of your losses when the market goes down; though, of course, you won’t make when the index rises either.

Say you split up your Canadian index investment into two parts: $90,000 in the XIU and $10,000 in HXD. That means when the market goes up 10 per cent, the XIU portion is worth $99,000, while the HXD units dips down to $8,000 for a total of $107,000, or in other words, $3,000 less than if you had just left all your money in the XIU. But when the index drops 10 per cent, the XIU units are worth $81,000 while the HXD units are worth $12,000 for a total of $93,000, or in other words, a $7,000 loss incurred as opposed to the $10,000 loss had you have had all you money invested solely in XIU.

2. The bullish-on-stocks/bearish-on-commodities hedge.

Let’s say you really like the Canadian energy sector – it just hit its record high – you like its long-term prospects to keep going up. But at the same time, you think the price of oil is unsustainable at its current prices and you know that the price of oil often has a direct impact on the shares of energy stocks.

How do you protect your investment from falling oil prices while staying bullish on energy stocks? Employ a similar strategy like the classic hedge outlined above: Buy a sector ETF that invests in Canadian energy stocks and then buy a bear fund that tracks the inverse of the price of oil. The Horizons BetaPro Oil Bear ETF has gone from as high as $25 to as low as $12.04 and is currently in the low end of that range.

3. Portable alpha strategy.

Ready to invest like the guys who run the Harvard endowment fund? Consider the portable alpha strategy.

Sounds complicated but the concept is quite simple: You eliminate market risk by investing in two different kinds of assets that have little correlation. It’s a favourite technique among many institutional investors but small retail investors can easily do it too.

Bull funds can help you do it since they can maximize your exposure to one asset class, while freeing up the other money to invest in other asset classes. A bull fund allows you to effectively double your exposure to the index, given that it ebbs and flows at twice the rate of the index it tracks. So, back to the example of the $100,000 portfolio: To partition it like a portable alpha manager, you’d take $25,000 and invest it in the HXU fund that follows the S&P/TSX 60 index, and because it moves twice the amount of the index, it’s like you’ve invested $50,000 in a regular index fund.

So the next move is take the remaining money and invest it in assets that do not follow the movements of the stock market, say, REITs or bonds. And by using the bull fund, you’ve freed up more money than would have with a regular ETF to diversify to other asset classes.

Special to The Globe and Mail