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.
Trailing 3-Year Return*
Trailing 5-Year Return
Trailing 10-Year Return
|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 January 1994-June 2010 period, 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%.
Essentially, investors have historically fared far better by incorporating into long portfolios the very short selling strategies that are often described as highly risky. How's that for irony?
But isn't the market back on firm footing?
Sure, the prospect of adding short-selling to your investment mix can be intimidating. And the psychological hurdle rises when the bulls are running the show.
Yet while stocks have been on a tear since late August and the U.S. economy's churned out some definitively positive data points, the reality is that not all is rosy. Core capital expenditures growth, for one, has hit the skids in recent months. Meanwhile, both the Fed and private firm RealtyTrac see more air beneath home prices, which could offset any wealth effect of a giddy stock market.
Finally, consider that every one-cent rise in gasoline prices sucks out $1.5 billion from household cash flow. With U.S. gas prices at $3.15 per gallon now, versus roughly $2.70 in September and a possible $4.00 in the future, the GDP impact could be meaningful.
This is all to say that Mr. Market may be poised to take a header. Specifically, margin debt levels and professional and amateur sentiment readings smack of a market that's been rising for no greater reason than the market's been rising.
An extended dose of downbeat economic data and related stock volatility could potentially send us back to the single-digit valuations we had in the 1930s and 1940s and, more recently, in the 1970s and 1980s.
Shy away from hedging? No, thanks.
The nuts and bolts of going long while getting short
The most straightforward way to gain short exposure is to sell short an ETF such as Vanguard Total Stock Market, a market proxy. Of course, during the next downturn, certain individual stocks will fall farther and faster. And that's where it gets tricky.
The restaurant industry, for instance, has cooked up a heaping helping of tenuously high price-to-earnings ratios. Among the potential short candidates, I'd consider Red Robin Gourmet Burgers, a North American purveyor of high-quality casual eats. Against an industry average of 19, shares trade at a 2011 P/E of 27.4. Given that Q3 operating margins slipped on higher costs, coupled with management's forecast of continued margin pressure and lower Q4 comps, the valuation gap looks downright implausible.
But if you believe in the U.S. consumer, this short investment could nonetheless leave you queasy. No problem, just pair it with a long position. Known as a pair trade, said investor hedges risk by shorting a weak industry player while simultaneously going long the shares of a stronger hand. On the latter note, I offer up McDonald's (NYSE: MCD ) , which has seen U.S. comps rise 3.8% through October 2010 and trades at a forward P/E of 14.7.
Pair trades can be tweaked to work well for any industry. Take energy, where one might be long-term bullish on global behemoth ExxonMobil (NYSE: XOM ) but wary that commodity fluctuations could drag on the stock. Solution? Long ExxonMobil and short the United States Oil Fund and United States Natural Gas Fund (NYSE: UNG ) . The latter should fall with gas prices, and, as a bonus, is structurally handicapped by negative roll yield.
Of course, an unpaired short can also make sense. But it's dicey. For example, casino operator Las Vegas Sands (NYSE: LVS ) trades at a forward P/E of nearly 30, but unlike certain competitors, it boasts enviable exposure to fast-growing Asian markets. A surer short may be found in online auctioneer MercadoLibre (Nasdaq: MELI ) . The stock trades at a higher forward multiple of 47.5 and faces looming competitive threats.
Finally, with certain names, the middle ground may be the best bet. Take the case of Cisco (Nasdaq: CSCO ) and Starbucks (Nasdaq: SBUX ) . The former looks cheap but could continue to suffer from lower government spending, while the latter's been contending with higher commodity prices.
Enter the world of options. Writing puts on either name would generate income in the near term and potentially lower a future buy-in price. On the other hand, employing a bull call spread would minimize capital at risk while offering compelling upside exposure.
As with long investments, the most profitable short positions are rarely in full view. Identifying accounting irregularities through cash-flow-versus-earnings discrepancies and problems with accounts receivable are excellent ways to identify such prospects.
Now, for those who are intrigued by the prospect of outperforming the market through a long/short portfolio but reluctant to make those nail-biting short and options-based decisions on their own, the Motley Fool is reopening its real-money long/short portfolio, Motley Fool Pro.
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