Most of what I’ve written about hedging is what I know — how a bond portfolio manager hedges a book of mortgage-backed securities.
I hope it’s been helpful for my readers to recognize the styles and methods the managers of these companies use, and their relative transparency and quality of disclosure on this front.
Jon Rosenbaum asked in a comment today:
“What is the best way to protect your principle and retain dividends for amreits? What hedging instruments work best?
What about SDS for general market drops? or some other vehicle?”
Before I take a shot, let me remind everyone that there is no perfect hedge. Back in the 80’s, the First Boston (today Credit Suisse) traders kept a small potted miniature (English) boxwood near their trading desk with the legend “The Perfect Hedge”…. Before I let go of the hedging lore from Wall Street, I need to repeat one other bit of wisdom, which, unfortunately, doesn’t answer Jon’s question.
“The only perfect hedge is a sale ticket.”
While true, when you sell your assets, you lose the future income. That’s the rub for retail investors, and, for that matter, for what we call the “real money” investors like insurance companies and pension funds. The need for future income overrides the reality that selling the assets may be the best thing to do sometimes.
A portfolio manager or a retired person generally doesn’t have the choice to just sit out during an apparently overheated market, because the insured pool for a life company continues to have claims, the retirees depending on the pension or annuity have to get their monthly checks, and the retiree living off their investments still has to put groceries on the table.
So let me start with what didn’t work for me, since it was perilously similar to Jon’s suggestion of SDS for protection against a general market move.
Back in 2009, I bought at nearly the right time (March), though with not nearly enough of my capital. By that fall, I was nervous with my gains, and thought a correction was due in all the deeply discounted mREITs, insurance and bank stocks I had bought.
I bought into leveraged inverse financial funds (first SKF, later FAZ) thinking that a general correction of the dozen or more financials I had ridden on the upwave would result in quick profits to offset the losses on the stocks. To help with the income issue (as I was also writing out-of-the-money calls on some of the positions), I wrote far out-of-the-money calls on SKF.
To make a long story short, I did keep the premium from the SKF calls, but the loss in principal as it collapsed, reverse-split, and kept going down was a largest enough loss to take away most of the gains I had originally sought to protect.
Why is that?
Because of the mathematics of those double and triple levered ETF’s. They are structured to provide the return for one day only. If, as is normal, a market does not go in one direction only, but up and down on successive trading days, the levered ETF will lose money overall.
Here’s how it works:
Say you have a portfolio that’s at $100 today, and you buy $50 worth of the double inverse ETF. If your portfolio went up by 2 points the first day, your inverse would go down by 2 points.
After Day One, your hedge is working.
But on Day Two, let’s say your $102 portfolio drops back down to $100. Your inverse will go up from $48 by twice the fraction that your long portfolio went down. That’s just under 2% (2/102), or 0.196%. Doubling that, the inverse goes up by 3.9216%, leaving its new price at $49.88. You’ve lost 12 cents due to the mathematics of daily compounding on the ETF.
It’s a mathematical artifact at work. If the market, and your portfolio value, go up and down over time, if you simply hold the levered ETF, you’ll end up with less money over time.
Having said that, I have had some success this year by buying next month out-of-the-money calls on triple-levered inverse FAZ when the financials have been strong for a few days and political risk is present before the weekend (e.g. Europe PIIGS crisis or the Congressional game of political hostage taking). When Monday comes, the news is usually enough to move the market up or down at the open.
Maybe a half hour after the open, I either close the option position with smallish loss (the news is good and my main portfolio is up or not being killed), or I look to sell a call option at a higher strike price than the one I bought on Friday (when the news is being interpreted as bad for financials). Whichever way the news drove the market that morning, by midweek it usually becomes clear that the world is not coming to an end, or that more problems are cropping up in what was supposed to rescue the world.
Since my main bias is toward protecting against disaster, building a position of “vertical” call spreads on FAZ at no cost or even slight profits gives me the kind of disaster insurance I’m looking for. I have no doubt that the market can punish me more than this small protection will give me, but I just don’t see another method that doesn’t result in losing so much money over time on “hedging” that my net worth goes down rather than up over time.
Hope this helps, Jon. Feel free to ask more questions.