Hedging Strategies for Small Investors

Ann C. Logue is the author of Hedge Funds For Dummies, which was recently released. She contacted Consumerism Commentary and offered to send a book for my review. I’ve been interested in hedge funds, and specifically in what individual investors can learn from these investments which are normally closed to everyone but very high net worth individuals and organizations. I agreed to review the book, and Logue has provided an excerpt:

Hedge funds capture headlines, but they aren’t even in the realm of possibility for most individual investors. Under the law, hedge fund investors need a net worth of $1 million or $200,000 in annual income. That alone keeps a lot of people out. But just because you can’t invest in a hedge fund — yet — doesn’t mean that you can’t take advantage of hedge-fund strategies to protect your investments in all types of market conditions. These include diversification to reduce risk and increase return as well as more aggressive techniques for adding risk, like leverage (investing with borrowed money), short selling (selling borrowed shares of stocks expected to fall in price), and using derivatives (options, futures, and so on).

A Diversified Portfolio Is a Hedged Portfolio
You have a choice of different investment assets: stocks, bonds, cash, real estate, and precious metals, to name a few. These assets all perform differently at different times over an economic or business cycle, which is why long-term investors usually hold a mix of assets, figuring that some years will bring fruitful returns and others will be down years. The process of mixing the assets that investors hold is known as diversification.

Because different assets have different risk and return profiles, they’ll offset each other to generate smoother long-term performance. Some years, bonds will be great performers but stocks will be disappointing. Other years, bonds will be not-so-hot and stocks will be burning up the charts. That’s why it’s important to buy some of each. Some people do this by working with a mutual fund or investment manager who promises a diversified portfolio, others simply buy a mix of assets to create diversification on their own.

To get started,
* If you hold mostly cash, you can buy bonds.
* If you hold cash and bonds, you can buy stock.
* If you hold mostly U.S. assets, you can buy in markets outside the United States.

This is a long-run strategy, although it can have short-term benefits. In the long-run, the performance of the different asset classes, working together, should lead to a solid long-run total return. In the short-term, you’ll have a little exposure to everything, meaning that you won’t miss out when one asset class is showing spectacular performance. A diversified portfolio might not have stellar performance in any one year, but in exchange, you’ll get consistent performance over the long run.

Margin and Leverage
Not all hedge fund managers structure their funds to reduce risk. Some take on huge risks, with the goal of generating huge returns in the process. The expected returns may be greater than anticipated for the amount of risk taken, but take note: Risk is taken. An easy way for you to follow this hedge-fund strategy and increase risk is through leverage — the use of borrowed funds to make an investment.

You can do this through a margin account. You can open a margin account at almost any brokerage firm through an application called a margin agreement. After the agreement is in place, you can borrow up to 50 percent of your investment — a rate set by the Federal Reserve Bank to ensure that markets function even if a crash occurs.

Here’s an example. Say you want to purchase 400 shares of a stock at a price of $25.00. Your total investment is $10,000, and you borrow $5,000 at an interest rate of 10 percent. The $5,000 loan you take out to buy the stock leads to a huge return if the stock price goes up (to $40.00). However, because you have to pay interest, the margin trade loses money if the stock stays flat or goes down. If the stock price declines, you may have to put more money in your account, too. The tradeoff for the increased return is increased risk.

Short Selling
Short selling is the process of borrowing a security, selling it, and then hoping that the price declines so that you can buy the security back at a lower price it in order to repay the loan. Short selling is a popular tactic with hedge fund managers, because it allows their funds to make money even when the markets are going down.

Short selling is also a form of leverage. Not only do you borrow the shares you sell, but also you can invest the proceeds of your sales into other securities. The risk? You need to cover the short at some point, an expensive proposition if the security goes up in price rather than down. And yes, if the security more than doubles in price, you can lose more than 100% of your original investment.

Keep in mind that whenever you borrow, you increase your risk. And, in the long run, markets have an upward bias as long as the economy is growing, so short selling goes against that trend. I’m not saying you can’t make money, but you need to do very careful research on the securities that you plan to sell short.

Derivatives
You can use derivatives like options and futures to protect your investment positions and to generate high levels of return. Derivatives transactions have built-in leverage because you put up only a small amount of money to buy exposure to a security’s price.

For example, a call option gives the owner the right, but not the obligation to buy a stock at a set price in the future. If the stock goes up in price, the option has a lot of value, especially relative to the price the owner paid for it. If the stock goes down in price, the holder is out only the price of the contract.

Say a stock has a current price of $61.00. The strike price (which is the price where the option can be executed) is $65.00, and the option price is $0.85. If you purchase options on 100 shares, then your total price is $85. Option contracts are priced on a per-share basis and issued to cover lots of 100 shares, so you would need one contract for each 100 shares, and you’re out the cost of the contracts no matter what happens.

A call option gives you the right to buy, and a put option gives you the right to sell. How might you use these options to hedge?

* If you want to protect a long position — that is, the price of securities that you own — you should buy a put. If the price goes down, you have the right to sell at a set price.
* If you want to protect a short position, you should buy a call. At that point, you have the right to repurchase the stock at a set price.

If you want to learn more about options and other derivatives, check out the courses offered by the Chicago Board Options Exchange and the Chicago Mercantile Exchange.

And Remember . . .
Not all hedge fund managers are showing spectacular returns, especially when fees are taken into consideration. Instead of bemoaning the fact that you can’t get into a hedge fund, think about how you can manage your own money to reduce risks and increase return. Even the smallest investor can do that, without giving up 20% of the profits to a fund manager.