This Single Strategy Delivers Superior Long-Term Returns

Hedging is for suckers, speculators, and scaredy-cats.

If you've been investing for any length of time, you've heard that refrain a time or two. The thinly veiled implication is that using options and short sales to limit downside risk is fundamentally at odds with the core principles of conservative long-term investing.

Fools, such thinking is two parts hogwash and one heaping helping of poppycock.

Your path to superior returns
In truth, it's the most conservative equity investor who should be most interested in hedging. But don't take my word for it -- the numbers speak for themselves. According to an August 2010 Credit Suisse report, a long/short approach has produced market-trouncing returns, in both the fairly short and the relatively long term.

The table below compares the historical performance of the Dow Jones Credit Suisse Long/Short Equity Hedge Fund Index (DJCS LSEQ) versus that of the MSCI World Index.

* Returns are cumulative as of June 2010.

Furthermore, consider the following data points:

• $100 invested in the DJCS LSEQ in 1994 grew to $465 as of June 2010, versus only $246 for a comparable investment in the MSCI World Index.
• During the period of January 1994 through June 2010, the DJCS LSEQ posted an annualized return of 9.8%, with 10% volatility. By contrast, the MSCI World Index produced annualized gains of just 5.6%, with far greater volatility (15.5%, to be exact).
• Finally, while the recent bear market (Nov. 07-Feb. 09) rocked the MSCI World Index, quashing it by nearly 54%, the DJCS LSEQ held up relatively well, falling only 22%.

In short (no pun intended), investors have historically fared far better by incorporating into long portfolios the very short-selling strategies that are often described as highly risky and wildly volatile. How's that for irony?

But isn't the market recovering?
Sure, the prospect of adding short-selling to your investment mix can be intimidating. And the psychological hurdle rises during market upturns.

Yet while the market has shot up since August and the National Bureau of Economic Research has officially closed the coffin on the Great Recession, the reality is that the economic signals are mixed. U.S. durable goods orders, for one, took a header in October. And inventories have now climbed for 10 consecutive months -- a sign of weakening end-market demand.

Finally (although this hardly completes the list of gloomy tidings), roughly 11 million homeowners remain underwater on their mortgage, which hardly bodes well for the post-holiday strength of the U.S. consumer economy.

This is all to say that the market may not be cheap. Yeah, it looks cheap, with the S&P 500 trading at a 2010 price-to-earnings ratio of roughly 16 and an even lower 13.7 times 2011 estimates. But the P/E multiple is, essentially, investor psychology in numeric form. And that means that it's nothing more predictable or rational than human sentiment.

Another bout of volatility -- whether in company earnings or economic data -- would have the potential to send us back to send us back to the single-digit valuations we had in the 1930s and 1940s and, more recently, in the 1970s and 1980s.

No siree, this is no time to shy away from hedging.

The nuts and bolts of going long while getting short
The most obvious way to add short exposure to one's portfolio is to sell short the common shares of economically sensitive, or fundamentally weak, companies. But that tactic has its drawbacks, including the prospect of potentially unlimited losses.

Investing with options instead offers a low-cost, defined-risk way to profit from a stalling rally.

Buying puts on the SPDR S&P 500 ETF, a market proxy, is probably the most straightforward way to short the market via options. Of course, during the next downturn, certain individual stocks will fall farther and faster. And that's where it gets tricky.

For instance, there could be ample air beneath the shares of banking behemoths Citigroup (NYSE: C) and Bank of America (NYSE: BAC), especially if the "mortgage putback" movement gains momentum. Alternatively, while economically sensitive commodity companies such as Vale (NYSE: VALE) and Hecla Mining (NYSE: HL) were a put-buying investor's dream in 2008-09, the Fed's weak-dollar policy could keep these stocks hopping, even if underlying commodity demand wanes.

Then there's the problem of high-flying stocks such as Amazon.com (Nasdaq: AMZN), Netflix (Nasdaq: NFLX), and Chipotle Mexican Grill (NYSE: CMG). Are the valuations on these names propping up the clouds? Who knows? The market will decide, and it will decide when it decides. Meanwhile, leery investors can generate income and hedge downside risk by selling puts and calls.

Fret not
Hey, the language of options can be intimidating. I mean, can the "bear put spread" and the "covered strangle" be both intelligible and legal in all 50 states?

Moreover, as with long investments, the most profitable options-based short positions are usually those that the market initially fails to recognize. Identifying companies' accounting irregularities through cash-flow-versus-earnings discrepancies and problems with accounts receivable or days sales outstanding are excellent ways to identify such prospects.

At the end of the day, though, the key to surviving a market juggernaut is to have at least some kind of short or hedged position. That could mean buying puts on an index-linked ETF or using a more sophisticated strategy.

Now, for those who are interested in using options to gain long/short exposure but reluctant to make the dicey decisions on their own, Motley Fool Options will be reopening for a limited time. Our analysts explain options fundamentals in plain language and provide ongoing coverage on all recommendations.

Intrigued? Explore your options. Enter your email address in the box below and receive a free report.