The Best Offense: Defensive Investing

Why do wealthy investors and institutions pay millions of dollars in admission fees to get into hedge funds? Because hedging–or using investment strategies that reduce financial risk–works. Says Nadia Papagiannis, editor of Morningstar Alternative Investments Observer: “Defensive investing can improve your long-term results.”

So, why doesn’t everyone do it? Well, hedge funds represent “the ‘velvet rope’ of the investment community,” explains institutional investor Wayne P. Weddington III in his book, Do-It-Yourself Hedge Funds (Grand Central Publishing; $24.99). “Yes, you can be invited to the party, but the guest list is predicated on you having a bank balance of more than $5 million,” the SEC requirement for investing in an unregulated fund. Aside from expensive initial investments, hedge funds present other barriers for average investors. Their fees are quite steep; and liquidity is very low, as many funds put limits on your ability to withdraw your own money. Another downside: Because hedge funds are not regulated by the federal government, many of them operate under extreme secrecy. Even investors aren’t privy to all the ways their money is being used.

Fortunately, you no longer have to own your own Caribbean island to participate in hedge fund strategies. Thanks to a handful of newly popular investment products, you can employ hedging techniques in your own portfolio–at a relatively low cost.

According to Morningstar’s Papagiannis, an increasing number of mutual funds offer strategies that hedge fund managers typically follow. “With these mutual funds,” she says, “the minimum investment might be a few thousand dollars and you have daily liquidity. Fees are relatively high for mutual funds, but still much lower than what investors pay for hedge funds.”

Several types of investment vehicles deliver hedging strategies:
Long—short funds: Out of some $33 billion invested in “alternative mutual funds,” long—short funds have almost $28 billion. They use some of their assets to buy favored stocks and other investments; these are “long” positions, in industry lingo, because they’re owned by the funds, which will profit from price appreciation.

These funds also go short: they borrow securities expected to perform poorly and sell them at today’s prices. If those prices drop, the funds will buy back the securities at the lower price, return them to the lender, and thus clear a profit on the deal. In a bear market, when most stocks drop, profitable short positions can keep long—short funds from being clawed too badly.

“Most long—short funds are net long,” says Papagiannis, “because it’s easier and less risky to make money on the long side than on the short side, and because over the very long run the stock market has produced a positive real return.” If a fund is 60% long and 40% short, for example, it is 20% net long. It probably will participate partially in a bull market and not lose as heavily in a bear market.

Market neutral funds: These funds are designed to be neither net long nor net short. They attempt to add value by picking winners, on the long side, and by identifying laggards, on the short side.

Arbitrage funds: Funds in this category try to

take advantage of market dislocations. In merger arbitrage, for example, a fund might buy the stock of the target company while shorting the shares of the acquirer. In convertible arbitrage, a fund might buy convertible bonds while shorting the stock of the company issuing the bonds. In these and other situations, the long—short structure provides downside protection while a skilled arbitrageur seeks to profit from mispriced assets.

How have these mutual funds performed? “They helped investors during the 2008 bear market,” says Papagiannis. The broad U.S. stock market (represented by the S&P 500 Index) lost 37% that year while the funds in Morningstar’s long—short category lost 15.4%, on average. That wasn’t a great performance but many investors would have been happy to lose only 15% in 2008.

Hedging against the downside usually means giving up some upside. Through the first 10 months of 2009, the long—short category gained only 7.5%, on average. During that time period, the S&P 500 was up more than 17% and the average domestic stock fund returned nearly 21%. Nevertheless, for the 22-month period (2008 plus 10 months of 2009), an investor would have been better off with the typical long—short fund than with the typical long-only domestic stock fund.

You might wonder, “Why do I need a long—short fund or any kind of alternative mutual fund? Why can’t I do it myself–go long on the stocks I like best, and go short on stocks I like least?” Frankly, short selling is not recommended for lay investors. It is complicated and extremely risky. Because short selling involves borrowing shares whose values can fluctuate wildly, you have unlimited loss potential if the stock you’re shorting shoots up instead of down.

ETFs: One way to avoid these problems is to buy “short exchange-traded funds,” also known as “inverse ETFs.” An ETF is a fund (often a collection of securities) that you can buy and sell on an exchange, just like a stock. In his book, Weddington, a partner at Brunswick Partners in New York, calls ETFs “the most effective instrument available to you to effect hedge strategies in your own portfolio. With ETFs you can truly accomplish what the professionals do.” Virtually all ETFs are index funds: they track a specific index. Inverse ETFs, though, are designed to move in the opposite of the index: If the S&P 500 goes down by 2%, for example, an inverse ETF based on the S&P 500 would go up by 2%. (A leveraged or “ultra” inverse ETF would go up 4%.) Of course, if the S&P 500 rises, the inverse ETF falls.

That may sound like an ideal way to hedge your stock market risk. You don’t need to set up a margin account; you can buy an inverse ETF through any broker, just as you’d buy a stock. There’s no interest to pay to carry the ETF and your loss is limited to the amount you invest.

So what’s the catch? “Inverse ETFs reset daily,” says Tom Lydon, president of Global Trends Investments in Newport Beach, California, and founder of ETFtrends.com. Thus, if the S&P 500 is up 1% on Monday, an inverse ETF on that index will fall by 1%. If the S&P 500 is down 0.4% on Tuesday, the inverse ETF will rise by 0.4%. And so on, day after day. Over time, the ETF’s result may drift from a true inverse.

For example, Vanguard Emerging Markets Stock ETF (VWO) tracks an index of stocks from the developing nations of the world. Those stocks were hit hard in 2008 so this ETF was down by 52%. You would expect an inverse ETF to be up by around 52% for that year but Short MSCI Emerging Markets ProShares (EUM) gained only 20%. Moreover, UltraShort MSCI Emerging Markets ProShares (EEV), which aims to double the inverse of the underlying index, actually lost 25%. “Inverse and leveraged ETFs are not for everyone,” Lydon concludes. “They are good to use in a situation where an investor wants to hedge current positions without having to sell them, or to capitalize on short-term moves in the markets.”

Papagiannis suggests that investors interested in hedging start with a long—short mutual fund, and perhaps some other alternative mutual funds, within their portfolio. “Shorting is not just the opposite of going long,” she says. “It takes very specific skills to successfully go short. Investors should look for funds managed by people who are experienced in short selling; the more concerned you are about stock market risk, the greater the portion of your portfolio you might allocate to alternative mutual funds.”

This article originally appeared in the January 2010 issue of Black Enterprise magazine.