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Forget the temptation to get “in” or “out” of the market. Have your cake and eat it too, with Hedging.
If there ever was a time to empty the investing tool shed to come up with a new set of ideas, this is it. To that end, there is a straightforward investing approach that you may already be using. However, if you use it in a different way, it could be a decisive factor in your retirement lifestyle.
I am as big a proponent of portfolio hedging as anyone you will find. Importantly, I am separating “hedging,” which aims to reduce fluctuations in your portfolio value, from “hedge funds.” A hedge fund is a private partnership, and many of such funds have become a compensation scheme masquerading as an investment vehicle.
However, hedge funds and hedged investors (like me) have been using various forms of portfolio hedging for decades. The focus of this article is just one form of hedging, called “arbitrage.” Here is a brief primer on arbitrage.
This is for educational purposes, so you can see a glimpse of what is out there beyond the usual 60/40 world of “asset allocation.” There is so much investors can do in bear markets to give themselves a fighting chance of staying right on track for their retirement, or staying in retirement.
The old way: using bonds to offset stock market risk
Bond yields are close to zero, unless you want to venture out into the more risky bond areas. And if you are doing that, you might as well invest in stocks.
In addition, as time goes on, the risk of massive inflation will rise. That means that for a while, bond returns could be worse than low. They could be decidedly negative. So, as I have written many times here before, there are not many reasons left to use bonds as an offset to a stock portfolio.
So, what do you do if you still believe (as I do) that the stock market is a very good long-term way to grow wealth for retirement? And, if you are in retirement or approaching it, how do you deal with the current, historically-volatile environment?
In a word…
This mysterious word, arbitrage, needs a definition. Simply, this is the idea of buying 2 investments that tend to move in the same direction, but at different speeds. The goal is to profit from the out-performance of one over the other.
And, since they are similar enough, it is likely that your gains or losses will be in a contained range. That is, you won’t have to deal with the “market is down 10% today, what do I do?” Nor will you have to hang on to the “I’m a long-term investor” mantra, which is more a decision to hope than anything else.
Here is a picture of what one such situation might look like. If the word arbitrage sounds too fancy (after all, it is often used by uber-rich hedge fund managers), just think of this as investing in securities in pairs. Sort of like a modern investing version of Noah’s Ark.
This chart covers the last 12 months, a time of rallies and crashes in the stock market. The blue line is an ETF that mimics an index of 60% stocks and 40% bonds. That’s the old way.
The orange line is a mix of 2 ETFs. 75% of it is invested in the S&P 500 ETF (symbol SPY). The other 25% was invested in an ETF that profits from a decline (not a gain) in the Russell 2000 Small Cap Index. That symbol is RWM.
The long and short of it
So, that orange-line portfolio had 2 stock index ETFs in it. However, instead of investing in both of them to go up, and creating the usual feast-or-famine scenario, we instead approach the stock market as a place where relative winners and losers can be identified. And, the cost of being wrong is reduced. The “net exposure” of that pair of ETFs to the stock market was about 50% (75% in SPY, which moves in the same direction as stocks, and 25% in RWM, which moves in the opposite direction of stocks).
This is only one pair and one time period. But the concept is the key: this worked out much better than the 60/40 portfolio because it was not as heavily exposed to the market’s downside, AND because the S&P 500 outperformed the Small Cap Index. That won’t always happen, but again, its the arbitrage concept that is the takeaway here.
More than one way to pair up
There is one other line on the chart. The purple line, like the orange one, is a pairing of SPY and RWM. However, here the weighting of the 2 is 50/50. That means that any performance will be due not to the movement of the “stock market,” but rather the difference in return between the Large Cap S&P 500 Index and the Russell Small Cap Index.
As you can see, this pair trotted along in a narrow range for most of this 12-month period. As of February 19, when the market peaked, it was up about 5.5% in 11 months, the worst performer of the 3 on the chart. But when all heck broke loose, the S&P 500 outperformed the Small Cap Index by a mile, before that relationship checked back a bit recently. At the end of the 12-month period, this strategy, the most conservative of the 3 portfolios shown, was the best performer. It out-performed that 60/40 mix by nearly 18%…in 12 months!
Investing for retirement in bear markets is not impossible. It’s just different. You need to expand your toolbox just a bit. Specifically, get out of that old mindset of rooting for the stock market to go up, and reckon with the “accident waiting to happen” that is bond investing for retirement. Instead, develop some basic opinions about market areas we think will appreciate more than others (or find someone who develops those opinions at a professional level). That can be the basis for a less-stressful approach during all markets, but especially during bearish times.
Related: Here’s Why Your Brokerage Statement Is About To Surprise You