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Friday, 19 October 2007

How to Protect Your Portfolio

By David Bogoslaw

Once burned, twice shy. Even though the major stock indexes are trading at record highs and concerns about a possible credit crunch-led recession have abated slightly, many of today's investors have vivid memories of the market meltdown of 20 years ago. No surprise, then, that one feature distinguishing the current stock market from the one that crashed in October, 1987, is evidence of more caution among investors.

It wasn't that way back when Gordon Gekko of Wall Street was telling investors that "Greed is good." Twenty years ago, traders in thrall to the possibilities of making money by exploiting the differentials between stock index futures and the underlying stock indexes were buying and selling without covering themselves with an opposing transaction, a strategy that would have afforded them some protection when their bets went sour.

Today, they're much more likely to put safeguards in place to hedge against downside risks. Since 1987, the average daily trading volume of options has more than tripled, with index options in particular seeing growth in volume, open interest, and liquidity.

More Players, More Protective Tools

The primary difference between today's index futures market and that of 20 years ago is that there's now a much larger pool of participants, including hedge funds, creating a more diverse and liquid market, says Scott Warren, managing director of equity products at the Chicago Mercantile Exchange, which specializes in index futures. Circuit breakers in the futures, cash, and options markets that temporarily halt trading after a drop of a certain percentage also limit the magnitude of bearish events, he says.

In addition to the market's much greater ability to absorb large buy and sell orders of stocks and options, there's also a much better understanding of the strengths and limitations of protection strategies, says Jim Bitman, senior instructor at the Chicago Board of Options Exchange's Options Institute. "People still remember 2001 and 2002 a little bit, so they're probably trying to take some protective measures," and leaving more money on the sidelines, says Jody Team, president of Team Financial Strategies in Lewisville, Tex.

To protect clients' portfolios, money managers are using a host of sophisticated hedging tools intended to offset risk to their core stock holdings. One such tool: inverse index funds. These so-called bear funds are designed to move in the opposite direction of the index to which they are benchmarked, such as the Standard & Poor's 500-stock index.

Inverse Index Investing

The inverse index mutual funds at Rydex Investments don't short the indexes themselves. Instead, they use derivatives such as index futures, which can be traded and rolled over into later periods more cheaply than shorting the stocks themselves, says Jim King, director of portfolio management at Rydex. They're still at risk of losing money, but they can't lose any more than they put into the fund, King says. Investors are "long" the fund, while the fund takes the short positions, but the returns are the same as if clients were actually short the index. "It's up to us to keep the fund from losing more money than it has," he says.

Inverse funds can be especially useful in retirement accounts, where investors don't otherwise have options to short the market. Among the 11 inverse funds that Rydex manages are a few that give shareholders twice the leverage to the underlying index. The Inverse S&P 500 2x Strategy, for instance, gives investors twice as much return for each percentage move down in the S&P 500, but it also generates double the loss for any uptick in the index.

A Little Leverage Goes a Long Way

One reason for the popularity of these extra-leveraged bets, also known as ultra funds, is that they give investors the same amount of exposure as the regular fund, with a commitment of only half the money. But because they're twice as risky, King says Rydex tries to make sure customers understand the implications and prefers they work with financial advisers instead of buying directly from Rydex.

Of course, leverage has to be used wisely. The use of stock index futures accelerated selling pressure in the 1987 crash, but King says that was primarily a result of the way they were used, as opposed to a fundamental flaw in the instruments themselves. "It all comes down to the degree of leverage," he says. "Our funds are leveraged at most 2 to 1. A person using index futures could get leverage approaching 10 to 1 if he wanted to. That's where folks get into trouble. They take on a lot of leverage, where even a small move in the market can wipe out their position."

The trick to making money from inverse funds is to invest in them before stock prices start to fall, says King.

A Healthy Margin

Having been caught in the downdraft in October, 1987, losing a lot of his clients' money, Joseph Biondo Sr. believes in keeping portfolio protection simple. Since the large amount of money borrowed on margin to boost positions was a key contributor to both the 1929 and 1987 crashes, "we limit the amount of margin we'll have a client use to 20% instead of the 50% cap that regulations (allow)," says Biondo, the founder and senior portfolio manager of Biondo Investment Advisors in Milford, Pa.

For a client who has put up $100,000 to buy $200,000 in stock, it takes just a 50% drop in the market to wipe out the initial investment and force the investor to use the remaining $100,000 to pay back the loan. "We'll only borrow 20% to buy stock, so essentially stocks have to go down 80% for a client to be bankrupt instead of 50%, and that's never happened," he says.

Hedging with Exposure to All Asset Classes

There seems to be an unspoken belief in the financial industry that history repeats itself, but Bill Neubauer, an independent financial planner in Miami, says he tries to position his clients for crises that haven't been seen before.

For Neubauer, the only way to really minimize risk is through extreme diversification, by adding more asset classes that behave differently from one another. Four years ago, he began adding real estate to clients' portfolios. Then he began to shift toward greater international exposure in all asset classes, expanding from stocks to include bonds, currencies, and real estate. International assets now account for 70% of his clients' portfolios, which total roughly $30 million.

"For them to have a hedging function, they have to be in fairly meaningful quantities," at least 5% of the total portfolio, he says. "The thing people really worry about is correlations and negative correlations being tossed out the window when everything goes down at once." Dispersing his clients' portfolios among five or six major asset classes and 18 subclasses has produced a much smoother ride, he says.

Targeting Vulnerable Sectors

Investors can also hedge based on a belief that one type of stock will do worse than other types under certain economic conditions. Team, of Team Financial Strategies, invests in inverse funds that track the Russell 2000 index because he thinks an economic downturn would be much harder on smaller-cap companies. But he balances that by concentrating his long positions in a small number of stocks that are owned by a few value-oriented fund managers he trusts and that trade at a discount of at least 30% to multiples like price-to-sales and price-to-earnings.

Exchange-traded funds that target particular sectors are another sharp tool for building protection into a portfolio. Kipley Lytel, managing partner at Montecito Capital Management in Montecito, Calif., has been buying shares of UltraShort Financials ProShares (AMEX:SKF - News), an inverse index ETF, on the belief that financial stocks are overpriced and still vulnerable to the credit crisis. "So as financials go down, we'll make money." Montecito's portfolio also includes hard assets like commodities, as well as high-yield and hybrid equity funds, like Hussman Strategic Growth Fund (NASDAQ:HSGFX - News), that can buy index put options.

The burgeoning portfolio protection strategies probably deserve most of the credit for keeping a lid on irrational exuberance, but the additional caution may also reflect the aging of the biggest investor population, the baby boomers. "They're a little more senior and mature. There's a realization that sensible returns -- between 7% and 15% -- are acceptable, where there was time in the 1990s and late 1980s when people wanted high 10s, low 20s returns," says Biondo. "As people get a little smarter and older, they realize that's not reality and that if you get those types of returns, they're short-lived."

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