After rallying 20% since the end of August, the stock market looks overextended and vulnerable to a correction in 2011. However, individual investors can still own stocks and protect their capital using the same techniques that sophisticated investors employ on behalf of their wealthy clients. I'll tell you how below, along with three trade ideas that stand to produce hedge fund-type returns. But first, let me explain just what I mean.
It's not about shooting for the moon
When most people think of hedge funds, they picture aggressive traders making highly leveraged bets. While that does exist, it's a misrepresentation of the industry. The main concern of people who invest in hedge funds isn't getting rich – they've already achieved that. Instead, these people aim to preserve their wealth.
Furthermore, hedge funds are just a part of their asset allocation. (So are equities, bonds, real estate, etc.) Institutions and high-net worth individuals entrust their assets to hedge fund managers not to earn huge returns, but to earn stable returns that don't move in tandem with the stock and bond markets. That way, if the stock market hits rough waters, their hedge fund assets act as ballast in their portfolios, contributing positively to overall returns.
The man who invented hedge fund investing
To understand how hedge funds produce these returns, let's take a lesson directly from the man who pioneered the concept: Alfred Winslow Jones. A Harvard graduate with a doctorate in sociology from Columbia, Jones had an eclectic career, including stints in the foreign service and as an editor at Time-Life magazines. In researching a Fortune magazine article on technical analysts in 1949, Jones made some contacts on Wall Street. He founded A.W. Jones the same year, pooling $100,000 together with four friends.
Jones' idea was to leverage his capital to buy stocks, all the while selling other stocks to offset some of his risk. For example, he might use his initial $100,000 to borrow $50,000. He would then invest $110,000 in stocks he found attractive, and sell short $40,000 of stocks he didn't like. Thus, $40,000 of his long positions were hedged, and his net exposure was $110,000-$40,000 = $70,000.
Hedge fund vs. traditional portfolio: Which is riskier?
A.W. Jones referred to this as a "hedged fund", which was ultimately bastardized into "hedge fund." Jones used to say he was using "speculative techniques for conservative ends." The speculative techniques refer to the use of margin debt in leveraging the portfolio up to $150,000, but how does this achieve a "conservative end"?
In the example above, Jones pegged his portfolio risk at 70%, less than the 80% risk of a $100,000 portfolio allocated 80/20 between stocks and bonds. Sure, if all stocks rose 10%, his portfolio would lag the straight stock and bond portfolio. However, if stocks declined 10%, it would outperform the conventional portfolio, thanks to its lower net exposure -- consistent with his goal of capital preservation.
Putting together your own "hedged fund"
One way to create a hedged portfolio is to put together long/ short stocks pairs -- i.e., a long position in one stock combined with a short position in another. In order to achieve returns that are unrelated to the broad market, you want to pair stocks that are similar in terms of industry, market capitalization, and other factors.
But you'll want to remember one key difference: You expect the stock you're planning to buy to outperform its sector, and the one you want to short to underperform. If you're right, the combination of the long and short positions will end up producing a positive return, however the market or sector performs.
Three long/ short ideas
How do you select your long/ short pairs? The following table contains three pair ideas in three industries. Each pair represents two competitor companies, but the long is a higher-quality business, and among the cheapest stocks in its industry on the basis of the forward price-to-earnings multiple. The short, on the other hand, is one of the most expensive. That combination of characteristics suggests these are attractive long/ short trades.
|Short: Abercrombie & Fitch
|Buy: Cisco Sytems
|Short: F5 Networks
|Short: Red Hat
* Based on next-12-months' EPS estimates. Source: Capital IQ, a division of Standard & Poor's.
Jeff Fischer uses similar strategies in managing Motley Fool PRO's $1.4 million real money portfolio. Jeff aims to hold roughly 70% of the portfolio in stocks, and up to 15% in shorts. Since inception in October 2008, he has matched the S&P 500's performance in a bull market with just half of the index's volatility. The market's end-of-year run-up now leaves SPDR S&P 500 ETF
It's your turn
If you're interested in protecting -- and growing -- your assets in 2011, using the same strategies that hedge fund managers use, enter your email below to receive Jeff's free report, along with an invitation to join Motley Fool PRO when it reopens in January. This is a no-obligation opportunity to consider investing alongside a professional with a proven track record. Now that's a proposition with a fantastic risk/ reward profile.
Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the other companies mentioned in this article. The Fool has created a bull call spread position on Cisco Systems. The Fool owns shares of Oracle. Motley Fool Alpha owns shares of Cisco Systems. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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