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TORONTO (GlobinvestorGOLD)—Many retail investors are coming out of this bear market a little poorer—and hopefully a little wiser. The wise investor has been taking advantage of low valuations over the past three years and, as markets advanced, turning losses to profits. The wise investor is also putting an effort into making sure those profits are preserved, and that's where a good recipe for home-made hedges comes in handy.
The purpose of a hedge is to offset investment risk. There is no single definition for a hedge but there are securities with hedge-like qualities to employ in a portfolio. The most basic is fixed income held to maturity. Interest yielding instruments such as quality bonds offset the risk that comes with investing in equities. If an investor incurs losses on the equity market those losses are offset by bonds, which produce a return in the form of interest payments regardless.
Other home-made hedges could include precious metals, natural resources or real estate. While all three are considered equity, their market performance often runs counter to the broader equity markets. Over the past three years the average global equity mutual fund lost 11.7 per cent annually. During the same period the average natural resource fund gained 11 per cent annually, the average precious metals fund got a 40-per-cent jolt and the average real estate fund increased 7 per cent.
And then there are hedge funds—also classified as alternative strategies. The majority of Canadian hedge fund portfolios employ long and short positions simultaneously. A long position makes the investor money when the security in question rises in value, while a short position is profitable when the underlying security falls in value. Hedge funds have been so successful at offsetting risk for the past three years that the average total return is flat.
Oddly enough, hedging pros say hedge funds are not true hedges. Bob Tebbutt deals in corporate risk management for Benson-Quinn-GMS in Toronto. Big institutional investors hire him to give their portfolios a safety net. Think of him as the guy who maintains the brakes on a car. He's not concerned with how fast it goes, or where it will be going. He just wants to be sure the brakes work when the car is heading for a brick wall. He says a lot of retail investors don't really understand hedge funds.
"It's a misnomer that hedge funds are a good hedging tool. They are funds of value directed by a trader or a number of traders," he says. To him, a true hedge is not intended to produce returns unless the underlying investment incurs losses.
Bob Tebbutt says the overwhelming majority of retail investors mistakenly ignore true hedging because of a common misconception about markets: "Retail investors always assume markets will go straight up over the long term. That's wrong".
He also believes the arsenal of hedge strategies he uses to reduce risk for big institutional investors can be applied to retail portfolios with assets of at least $250,000 (U.S.). He recommends high net worth retail investors "insure" their holdings by setting aside 4 per cent of their total portfolio assets for hedging purposes no matter what the market climate.
"It's wise to have life insurance, it's wise to have car insurance, and it's also wise to have portfolio insurance" he says.
Mr. Tebbutt's hedges can get very complicated but they often include derivatives such as options that are offset against the broader portfolio. An option gives the investor a right—but not an obligation—to buy or sell a security at a future date for an agreed upon price. In theory, if losses are incurred in the broader portfolio the right will be exercised at a profit. If the right is not exercised after a specified period, the option expires and the investor forfeits the money. In that case the money the investor paid for the option, the premium, is the cost of having portfolio insurance.
One risk that snuck up on most unhedged Canadian investors this year is the rapid rise in the Canadian dollar. Returns on U.S. dollar-denominated securities are being swallowed by the falling greenback. Mr. Tebbutt says a good currency hedge on the options market will cost the investor about $2,000 (U.S.) a year per $100,000 Canadian dollars, but the payoff is the assurance that your dollar will always be worth a dollar.
For lower net worth portfolios there are not a lot of true hedge instruments that make sense from a cost perspective. In the case of currency fluctuations the only advice Mr. Tebbutt can give is to be aware of the risks when making the initial investment decision.
More important, he advises lower net worth investors to "always, always, always" place stop loss orders on their investments. A stop loss order automatically triggers a sell if the value of the security falls below a predetermined level. There's a small brokerage charge but consider it another cost of portfolio insurance.
One risk for any sized portfolio is inflation. It's not a big deal now—but neither was the rapidly rising Canadian dollar a year ago. The most common hedge for inflation is gold because its value tends to increase in proportion to increases in the consumer price index, known as the CPI. Mr. Tebbutt believes gold should be a part of any portfolio not only to ward off inflation but to hedge against any disaster that could be inflicted on an economy. When things get bad, gold tends to increase in value.
Responding to the retail investor's appetite for a gold hedge the Millennium Bullion Fund was introduced on the Canadian market earlier this year. It's an open-ended precious metals fund that holds actual bars of gold, silver and platinum. The fund is RRSP eligible, which means it can be held in a tax-sheltered registered retirement savings plan.
Fund Manager Nick Barisheff recommends 5 per cent of any portfolio be comprised of gold and precious metals but recommendations vary from one advisor to the next.
A hedging plan is rarely considered in the average retail investment portfolio and there are a couple reasons. First, retail investors normally start with a small amount of cash and every dollar contributed is intended to produce a return. Second, investment advisors rarely recommend true hedges because the home-made hedges mentioned above are cheaper and provide no financial compensation for the investment advisor in the form of commissions. In the end, hedging, or the extent of hedging is a personal matter that comes from the individual's tolerance for risk.
Dale Jackson has been a producer at Report on Business Television since its launch in September 1999.