Hedging: A Dirty Word or a Useful Strategy?
by Ken Faulkenberry
Hedging has become somewhat of a dirty word lately. People correlate it with Hedge Funds and “betting against America”. In reality, hedging, like many things (i.e. alcohol), can be abused or used incorrectly and cause harm, but when hedging is used correctly it can be a useful tool or a prudent necessity. A homeowner will usually hedge the chance of a fire destroying his home by purchasing fire insurance. Hedges can also improve the safety and reduce risk in an investment portfolio. Hedging is a portfolio diversification strategy to reduce risk by owning something that is correlated inversely to other assets in the investment portfolio.
Owning precious metals investments, including gold and silver mining stocks, are a hedge. The primary purpose of owning these investments is because they do well during times of rising inflation or economic and political turmoil. These are the times other asset classes like stocks, bonds or real estate may not do well. Therefore it is prudent to hedge a portfolio by owning some investments related to precious metals. During periods of economic stability most portfolio managers recommend a target of 3-7% of a portfolio in precious metals related investments, but that percentage could be much higher at certain times. It is important to constantly monitor economic and political risks to achieve the optimum asset allocation in precious metals.
A recent popular vehicle for investing, Exchange Traded Funds (ETFs), provides an instrument that moves inversely, or the opposite direction of a stock market index. Some of these inverse ETFs even move 2 or 3 times as much as the underlying index. The need for frequent rebalancing makes inverse ETFs dangerous for anyone who doesn’t understand how they work or does not pay close attention to the need for frequent rebalancing. In other words, inverse ETFs require an active asset allocation strategy.
For investors who employ an active asset allocation strategy, the inverse ETF can be a useful tool by allowing an investor to take the market risk partially or wholly out of one’s stock portfolio. For example, let’s say you own $100,000 of 20 great companies with solid balance sheets and high dividends, but believed strongly the stock market is going to decrease in value. You may not want to sell your stocks so you buy $50,000 of an ETF that moves two times the inverse of the market. You now have removed all the market risk from your portfolio of stocks. If the market moves lower, as you believed, you will make money on the ETF to make up for losses in your stocks. Of course, if you are wrong and the market moves higher, you will lose money on the ETF that will offset the gains in your stocks. The purpose is to continue receiving the dividends and not incur the taxes and commissions selling and buying your 20 stocks.
Hedging is an important and useful diversification strategy to reduce investment risk and improve long term portfolio performance. It is also a strategy that requires careful application, monitoring, and frequent rebalancing. Properly used, hedging can reduce investment risk.
About Arbor Investment Planner
The Arbor Investment Planner provides the Arbor Asset Allocation Model Portfolio (AAAMP) which uses hedges to reduce portfolio risk. Investors use the AAAMP as a guide but stay in control of their assets, and make their own investment decisions. The AAAMP uses precious metals investments and inverse index ETF’s to maintain asset allocations at levels believed to be optimum for the current investment environment. Rebalancing is taken into consideration in Trade Alerts sent to subscribers. The AAAMP is updated with every trade or major market move in order to stay disciplined and focused on our asset allocation. More Information is available at: www.ArborInvestmentPlanner.com.
