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How to run your portfolio like a hedge fund

Risk reduction or spinning a roulette wheel?

Wouldn’t it be great if you could reduce the risk of investing in the stock market – or in gold or oil or any other risky asset?

People pay a fortune to hedge funds that claim to reduce the risks of investing – but can you do it yourself?

In this article I’ll introduce some techniques used by hedge fund managers and others to ‘hedge their bets’ when investing.

A couple of these are just basic principles of good investing.

Others are employed by hedge funds to reduce volatility, or to try to deliver absolute returns for investors.

Be aware that big hedge funds have teams of Phds working on expensive proprietary models that aim to turn a 0.05% profit from the difference between Japanese and Taiwanese rates, or something equally bananas.

I’m not going to tell you how to build such a black box software model – as if I knew – but rather just discuss some old-fashioned hedging methods.

Also, be aware that most hedge funds lose money eventually. And even if they don’t, reducing risk invariably means reducing rewards. (If it looks like it doesn’t then you don’t know where the risk is!)

An absolute return fund may make 8% a year every year, but it won’t hit 25% in the year the market soars, because of all its hedges and safe holdings.

Wealth warning: Tips 3 to 6 all strongly belong to the realm of active trading. Most investors will likely do better with a cheap ETF-based portfolio that they rebalance once a year than by messing about with this stuff. Shorting is risky, and in some circumstances your losses are unlimited.

1. Portfolio diversification

Many hedge funds make a big play of their sophisticated diversification.

Diversification simply means mixing up the assets you hold:

  • The least diversified portfolio would hold one stock
  • A more diversified portfolio would hold a tracker (and hence all stocks)
  • Further diversification would add more asset classes

The assets in your portfolio should move in different ways over time, so the winners compensate for the losers. In times of stress, however, assets tend to become more correlated.

Ideally, your diversification reduces risks more than it reduces returns – something far easier written than done!

Upside: Diversification reduces portfolio volatility, and also the risk of under-performance versus the market.

Downside: Your returns will be lower than if you’d picked and held only the winning assets. (A big if…)

2. Position sizing

For passive investors, this means allocating your money sensibly between cash, equities, bonds and other assets.

If you pick stocks, you should not allow any position to get so big that it would cause you great distress if you lost everything.

Active traders think in terms of their total ‘pot’, and have rules about how much they will risk – say 2% when putting on a trade, and no more than 50% of their funds invested at any time.

Upside: The money at risk is obviously limited to what you’ve invested.

Downside: You’ll never make as much as someone who bets it all on black. Then again, he’ll eventually go bust.

3. Seek your ‘alpha’ by shorting the market

This is the classic hedge fund strategy, which I’ll present in a very simplified form.

Imagine you think shares in Monevator Trucking Ltd will do well over the next 12 months – but you also think the stock market overall is expensive.

You know that when the market falls nearly everything sinks, but you still think Monevator Trucking will fare better than most shares.

What you can do is spend some of your money buying shares of Monevator Trucking Ltd, and use another portion to ‘short’ the market index (that is, you bet the market will fall).

If you’re right about Monevator Trucking doing better than the market, you’ll make a profit whether or not the market falls, provided you size your stakes correctly.

  • If the market goes up, you’ll lose on your short – but Monevator Trucking will go up even more to compensate
  • If the market goes down, you’ll lose on your Trucking shares – but you’ll win because your short will capture the bigger market fall

Congratulations! You’ve just extracted the ‘alpha’ – your stock picking skill – from the ‘beta’ – the returns from the market.

That’ll impress them in the pub!

In theory you can also hedge out other risks such as falling oil prices when investing in oil shares, or currency risk. In practice it’s a lot harder than it looks.

Upside: If you’re great at picking stocks and you hedge properly, you can’t lose.

Downside: Can’t lose? Get your stock picks wrong and your losses will be magnified. Also, you may need to use leverage to see a decent return, which hugely increases your risk.

4. Pairs trades

With a pairs trade you’re getting more specific about your hedging.

Returning to Monevator Trucking, you could hedge away the risk of the transport sector collapsing (rather than the whole market falling) by shorting a rival company, such as Oblivious Transportation.

If you’re right with a pairs trade, you’ll win because your long investment will do better than the stock or sector ETF you short.

Shorting can be done using options, contracts for differences, or my preferred route – a spreadbet. All have risks and extra costs, and most investors shouldn’t even touch this stuff.

Upside: More finely-tailored risk reduction than shorting the market. Great if you’re a genius.

Downside: You’ll get burned if you’re wrong – or if you’re right but the market doesn’t know it yet.

5. Cut your losses

This is a pretty simple technique. If you’ve got a portfolio of shares, it’s better to cut your losses when shares fall, and to hold on to your winners as their value keeps rising.

In this way, your winning shares could multiply to several times their value, sufficient to make up for your capped losses.

Active traders take it one step further by using stop losses to protect their gains when their shares rise in value.

As a fundamentals-based investor, this makes little sense to me – if a share is attractive at £10, it’s even more so at £9. But that’s what they do.

Upside: Your investments won’t plunge to zero – individual losses will be capped to where you set your floor.

Downside: In practice share prices wobble around, forcing you in and out and increasing your costs.

6. Follow the trend

One reason active traders are happy to cut losing positions quick is because they believe, with some justification, that shares tend to trend.

If shares are falling, the chances are that over a particular time period they will keep falling. And vice-versa.

Hedge funds that are buying the market in January might be selling it (shorting) by April after two down months. This flexibility enables them to make money whether the market rises or falls.

Upside: There is some academic evidence that momentum-based investing works, and being able to go long or short means you can always profit.

Downside: You’re easily caught when the market turns. Shorting increases your risk compared to going long, as the market tends to go up over time.

{ 8 comments… add one }
  • 1 Financial Samurai January 14, 2010, 8:36 pm

    Mate, u starting ur own hedge fund? Hope u don’t charge me 2 and 20!

  • 2 Faustus January 14, 2010, 9:34 pm

    Thanks – another interesting post.

    I always thought that many shorting options were extremely risky because there was no limit to the downside (i.e. you can lose more than you wager). I suppose sticking to Short ETFs tracking indexes would be one way around this, but I’ve not seen very many of these in Britain.

    On Position Sizing, it would be really helpful to know what the correlation is between different asset classes in Britain – Property (via Reits) Equities, Bonds, Commodities, and Cash. At the moment it’s easy to find plenty of people who think all these classes are expensive, which makes hedging this way seem like guesswork!

  • 3 The Investor January 14, 2010, 11:22 pm

    @Faustus – Quite right about some forms of shorting (such as spreadbets) though other methods you can limit your loss in advance (where your option expires worthless). Let me re-iterate: All this stuff is risky, in the proper sense of the word. Most people should start with passive investments, and then maybe try buying some stocks with some money they can afford to lose. Shorting is for advanced investors only!

  • 4 The Investor January 14, 2010, 11:22 pm

    @Sam – Hah, nah but watch this space my friend. Will have some news next week. 🙂

  • 5 ermine January 15, 2010, 11:11 am

    This needs a bigger wealth warning 🙂 Working out how much short you need to buy to protect a long isn’t as straightforward as it seemed to me when I tried to short my employer to protect the fall in share price of employee shares I had bought.

    These have to be held for five years but are purchased at a 41% tax advantage. Either I screwed up or the spread betting firm I used has a tracking error, as results quickly showed me this was a pool too deep for me to swim in. Counterintuitively, while my employer’s share price has gone down the pan, the combination of the 41% tax advantage and the dividends over five years mean I’m still reasonably well ahead.

  • 6 The Investor January 15, 2010, 2:04 pm

    @ermine – Indeed, and that’s a relatively simple case. (Re: The tracking error, I presume you took into account any dividend payments and interest due through leverage?)

    Trying to hedge out for example the movement in the oil price from the performance of a small-cap oil explorer is rocket science, which is why so many Phds work for hedge funds.

    This article should be considered as a bit of insight into how hedge strategies work, and as I hope I said sufficiently inside the article, NOT as a suggestion anyone use them. Perhaps I’ll change the word ‘Note’ in the alert box near the start to your phrase ‘wealth warning’.

    Thanks for the heads up. 🙂

  • 7 ermine January 15, 2010, 3:54 pm

    I think I demonstarted several of the things that one shouldn’t do when investing. Basically a divison at work was caught cooking the books, and it came out and the share price started to dive. I was looking to hedge the value of the 5 year pipeline of shares I had bought which were in the tax embargo. and I did it in a hurry. When the volatile price started to go up and the first margin call came I figured I should eat the £500 loss and chalk it up to education. As Buffett said, don’t buy what you don’t understand.

    I consider myself reasonably numerate, and I knew exactly what my real shareholding was. However, what I didn’t get right was how IG Index denominated the company, ie how many IG units to buy to hedge x real shares. When IG wanted £500 more, I couldn’t convince myself the value of my tax-embargoed shareholding had gone up by £500, so I was on the wrong track or too highly geared. I’d be interested to know how one should go about that sort of thing. The relationship didn’t seem to be one to one

  • 8 The Investor January 18, 2010, 1:14 pm

    @ermine – I’m sure you already know this, but for a one-to-one correlation you would have to size your position to be equivalent to the amount of movement you’d see if you were holding the equivalent basket of shares.

    i.e To ‘recreate’ (ignoring costs/spreads etc) a £10,000 holding of shares that cost £1-00 a share, an investor would bet £100 a point (a penny) – since an increase of 1p in the real-world share portfolio would be equal to 10,000 x 0.01 = £100.

    It’s very easy to get lost in the figures, or to accidentally take on huge leverage.

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