Hedging an Actively Managed Index Portfolio

[mattcorbitt]

I'm curious to get some insight on hedging methods for an actively managed index portfolio. I'm familiar with the general ways that hedging is done (short positions, buying puts, inverse ETF's, etc.) but I wanted to see if anybody hedges their index portfolio and how different strategies have worked for them.

I just switched over from a stock/mutual fund portfolio at the end of last year and now I'm actively managing indexes. I've tried to calculate the volatility of my portfolio to the best of my ability and it appears that my beta is about 1.23. I'd like to reduce my losses over time, even if it is at the cost of slightly increased beta and slightly decreased upside in bull markets. In reading about various hedging strategies, examples always seem to be done with stock portfolios. So it seems that there is an inherent assumption that the portfolio manager believes his stock picks will beat the index - an assumption that I do not make for my own stock-picking ability.

As an example, if you wanted to hedge your exposure to financials, say you have a long position in four financial stocks that you like and you take a short position in XLF as your hedge. How have people taken a similar strategy and applied it to an index portfolio? Certainly it doesn't make sense to have a simultaneous long and short position in the same index but I'm looking for something beyond market-timing to improve long-term returns by reducing losses.

[knordmo]

Hi, I have been working on this as well. Outside of the usual manner of hedging, I was thinking about "wrapping" a structured note around portfolios which would provide some floor level of total portfolio protection with the trade off of some upside cap. I am meeting with a guy in a couple weeks to see how we might do this and how much it will cost. I suppose you could do the same for certain ETFs or groups but, it is probably easier to collar those with puts and calls. I have done covered call writing on portfolios of ETF quite extensively but, it is very challenging to manage when you are running multiple separate accounts. Be curious to know if you've done much of this and if so, how have you managed it? It is certainly not a hedging strategy but has provided a nice level of return enhancement of late.

Kim Nordmo

[lariw]

the gateway fund (gatex) is a true "hedged fund" on the s+P, Basically they employ a covered call on the s+p combined with out of the money puts. It would perhaps make sense as an overlay on part of a portfolio or a tactical addition if you are into mkt timing. Basically it has limited upside and limited downside . It will outperform the s+p in mkts that are flat to slightly up or down while taking in the option premium. It performs best when the VIX is at high levels.

But the classic insurance of course would be to hold out of the money puts which literally are high deductible relatively low cost insurance.

[masmas]

mattcorbitt,
You've basically mentioned most of the ways a retail investor can hedge their portfolio; and all can work. I, for example, sell calls, buy puts, and use inverse etfs, as you mentioned. They can all work. You just need to think through exactly what you want to insure against and at what cost. I recommend a thorough understanding of exactly how each of those tactics will actually work (especially volatility sensitivity).

I have a question on your comment about your "beta". What are you benchmarking yourself against? The S&p 500? If so, what are you investing in? As an index investor your beta should basically always be 1.0.

For example, if you own 60% S&P 500 and 40% Russell 2000 I would expect your benchmark to be...... 60% S&P 500 and 40% Russell 2000.

[mattcorbitt]

I used www.riskgrades.com to calculate my beta, maybe it's not accurate.

My portfolio breaks down roughly like this:

Diversified US Equity: 44%
Diversified International Equity: 25%
Emerging Markets Equity: 20%
Fixed Income: 3.5%
Commodity Futures: 4%
Commodity linked Equities: 3.5%

[masmas]

I'm sure the beta was calculated accurately. My point is simply that a "beta" must be calculated by using your portfolio and a benchmark. For U.S. large-cap equity the S&P 500 is the most often used benchmark. However, when your portfolio consists of securities dissimilar to your benchmark it becomes a poor measurement. In your case, no more than your 44% of your portfolio is large-cap US equity.

For further example, if you are a mutual fund manager and you primary invest in the U.S. large cap space the S&P 500 is a meaningful benchmark. However, if you are a foreign bond trader the S&P 500 would be a useless metric. The same goes for everything in between. Even a mutual fund investing primarily in U.S. small caps wouldn't use the S&P 500 in their metric (they'd probably use the Russell 2000); they're simply measuring different things. It is important that you establish metrics: You just need to make sure your metric is informative.

I'm sure there are a number of calculators available on the internet for these things. I would try to find one that lets you select which benchmark to use. For example, MSCI Barra publishes a number of indices for U.S. and global equity. If you could use a benchmark that includes a mix you'd have a much more accurate, and useful, beta measurement.

And while beta can be a useful metric I would stick with figuring out an informative risk-adjusted metric (like the Sharpe ratio) to really compare your returns to whatever benchmarks you select. Beta is really only a measure of volatility; it does not take actual returns into account.

Finally, sorry for taking your thread off into a secondary path... I've been spending way too much of my time the past few months working on these problems.