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.