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How to Hedge Your Portfolio: A Primer

Lawrence Meyers

One of the central tenets of my stock advisory newsletter, The Liberty Portfolio, is to recognize that almost all portfolios – professionally and private managed – are broken, because they fail to adequately account for risk. A hedge can help you mitigate that risk.

Risk is everything. Yet there is no way to rate a portfolio based on risk.

There is no number you can point to, in the same way you can point to an energy rating for an appliance, that indicates how much risk you are taking in your diversified portfolio.

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I guarantee that you are taking far, far more risk than you think or that you can tolerate.

In 1983, the late Harvard Business Professor John V. Lintner delivered a landmark paper entitled, “The Potential Role of Managed Commodity-Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds.”

The conclusion was that portfolios of stocks and/or bonds, combined with non-correlated investments, showed substantially less risk at every possible level of expected return than portfolios of stocks and/or bonds alone.

That’s because investments that do not move in tandem with the market (non-correlated investments) reduce overall volatility, which is the core element of risk.

The Liberty Portfolio aims to have high non-correlation to the market. Here are some ideas for non-correlated investments, or “hedges”, that you may want to consider.

Diversification as a hedge

Although almost every category of stocks and bonds are now highly correlated to the overall market, your first step is to diversify and to diversify very broadly. One of the big myths in investing is that you are considered diversified if you have some arbitrary split between stocks and bonds, like 60-40 or 70-30.

That’s nonsense.

To even begin to get some notion of diversification, you need to have assets spread among both value and growth stocks; large, medium, small and micro-cap stocks; REITs, preferred stocks; individual bonds (not ETFs); muni bonds; real estate; commodities; exchange-traded debt; managed futures; alternative investments; CEFs; BDCs, options – and this list isn’t even comprehensive.

The more diversified your portfolio is, the less volatility it should have and therefore less risk. But this is not as true as it once was. From 1990 – 2000, the MSCI EAFE International index was only 24% correlated to the Russell 1000 Growth Index, only 17% correlated to the Russell 1000 Value Index, and only 41% correlated to the MSCI Emerging Markets Index. Most indices were also less than 50% correlated to each other.

Today, however, almost everything is 100% correlated to every other index.

Go Short

Most investors probably have some mix of ETFs and stocks. However, even as the market moves around, it may be worth considering having a short position in some ETFs. Going short certain ETFs may not only provide you a hedge against your ETFs, but against your individual holdings, giving you some small degree of non-correlation.

For example, suppose you have a basket of large cap stocks. Maybe you think that these “blue chip” stock are “safe” because they are all the big legacy names. You might consider shorting the crazy momentum tech stocks, such as Facebook Inc. (NASDAQ:FB), Netflix, Inc. (NASDAQ:NFLX) and the like. Well, you can short the entire go-go-internet sector by shorting the First Trust Dow Jones Internet ETF (NYSEARCA:FDN) which holds all of those big names.

Another consideration would be to short the Russell 2000, which represents the smallest 2,000 stocks out of the largest 3,000 stocks in the market. You could do this via the ProShares Short Russell 2000 (NYSEARCA:RWM). Mind you, the Russell 2000 does have a fair degree of correlation with the entire market so it’s not a complete hedge.

Non-Correlated Assets

This is the most critical element of risk reduction. These assets are most considered “alternative investments.” This could literally mean anything from fine art to diamonds to structured loans to, well, just about anything that isn’t a stock or a bond.

Finding publicly traded vehicles for these investments, however, is challenging. One place to look at is individual junk bonds. This is different from an ETF of junk bonds, because there is actually more risk and correlation with an ETF than individual bonds. With individual securities, you can fully assess the financials of a company and determine, in conjunction with rating agency indications, how safe a bond is.

Here’s another example: IQ Merger Arbitrage ETF (NYSEARCA:MNA). This ETF invests in companies in which a merger arbitrage exists. That is, if a company such as Time Warner Inc. (NYSE:TWX) is trading below its acquisition price, the fund might take a position in TWX. It will also may be long and/or short treasury bonds and bills, or short global equities as a market hedge.

The Liberty Portfolio actively engages in the purchase of non-correlated assets, as well as engages in swing and options trades to reduce risk, increase current income, and is targeted for a minimum ten-year holding period.

Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He owns RWM and has sold naked puts against TWX. He has 22 years’ experience in the stock market, and has written more than 1,600 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.

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