mlk_man
Banned
Hedging Your Bets Against Falling Markets
Mark Salzinger
The No-Load Fund Investor
he idea of protecting your nest egg against down markets is certainly appealing. After all, since the market reached a bottom in October 2002, small-, mid- and even some large-company stocks have notched such impressive gains that few stocks are inexpensively priced right now.
Mutual fund companies are attempting to offer average investors the types of sophisticated strategies that hedge funds use. The aim of such funds, which typically are called "long-short" or "market neutral," is to reap a steady return with less risk through bull and bear markets. They're even being tracked now as a category by fund-rating firm Morningstar, Inc.
But these funds have many shortcomings. Most charge steep management fees and other expenses... the use of hedge-fund practices by mutual funds -- such as selling stocks short to profit from declines in price -- is generally not time-tested... short-selling strategies lose money in extended bull markets... and over the long term, these defensive strategies are swimming against the tide. On average, stock prices tend to rise, not fall.
There is one "hedge-like" fund on our buy list -- Schwab Hedged Equity (SWHIX). Its institutional class of shares (SWHEX) -- which has the same strategy but a longer track record than the retail class -- has gained 18.4% annually over the three years through February 28, vs. 17.1% for the S&P 500 stock index. The fund is not "market neutral" -- it doesn't have nearly as many short positions as traditional long positions -- but the risk is low to moderate. It doesn't make risky sector bets, such as going "long" on energy stocks and "shorting" tech stocks. Instead, it maintains exposure to a rising market but keeps some assets in short positions to add to returns while protecting against a downturn.
Best funds: Keep no more than 10% of your assets in any long-short fund. For the rest of your portfolio, the tried-and-true formula is best -- a well-diversified portfolio that includes bond funds and money market accounts. Rising interest rates mean that you can get yields of 4% in some money market funds now.
The best way to "hedge" against stock market declines is to keep a mix of growth, value, equity-income and international funds, and make sure you have exposure to small-, mid- and large-sized companies. If you are a safety-first investor, aim for total portfolio volatility that's about half that of the broad market. So if the market drops 10% in a year, your total portfolio would drop by only about 5%. A portfolio of 45% US stock funds, 5% international stock funds, 35% short-term bond funds and 15% money market funds should do the trick.
Mark Salzinger
The No-Load Fund Investor
Mutual fund companies are attempting to offer average investors the types of sophisticated strategies that hedge funds use. The aim of such funds, which typically are called "long-short" or "market neutral," is to reap a steady return with less risk through bull and bear markets. They're even being tracked now as a category by fund-rating firm Morningstar, Inc.
But these funds have many shortcomings. Most charge steep management fees and other expenses... the use of hedge-fund practices by mutual funds -- such as selling stocks short to profit from declines in price -- is generally not time-tested... short-selling strategies lose money in extended bull markets... and over the long term, these defensive strategies are swimming against the tide. On average, stock prices tend to rise, not fall.
There is one "hedge-like" fund on our buy list -- Schwab Hedged Equity (SWHIX). Its institutional class of shares (SWHEX) -- which has the same strategy but a longer track record than the retail class -- has gained 18.4% annually over the three years through February 28, vs. 17.1% for the S&P 500 stock index. The fund is not "market neutral" -- it doesn't have nearly as many short positions as traditional long positions -- but the risk is low to moderate. It doesn't make risky sector bets, such as going "long" on energy stocks and "shorting" tech stocks. Instead, it maintains exposure to a rising market but keeps some assets in short positions to add to returns while protecting against a downturn.
Best funds: Keep no more than 10% of your assets in any long-short fund. For the rest of your portfolio, the tried-and-true formula is best -- a well-diversified portfolio that includes bond funds and money market accounts. Rising interest rates mean that you can get yields of 4% in some money market funds now.
The best way to "hedge" against stock market declines is to keep a mix of growth, value, equity-income and international funds, and make sure you have exposure to small-, mid- and large-sized companies. If you are a safety-first investor, aim for total portfolio volatility that's about half that of the broad market. So if the market drops 10% in a year, your total portfolio would drop by only about 5%. A portfolio of 45% US stock funds, 5% international stock funds, 35% short-term bond funds and 15% money market funds should do the trick.
