• “Is it possible to make a diversified portfolio with other financial instruments like per example Futures contracts?”
• “How do money managers manage their portfolio risk and hedge their positions with currencies, commodities, bonds, indicies, or interest rate contracts?”

Let us begin, by presenting to you some of the most basic strategies to hedge your equity portfolio. These strategies have a focus on reducing volatility and enhancing return potential. Each strategy can have a unique role within a diversified portfolio.

MARKET NEUTRAL

• Seeks to neutralize market risk and generate positive results regardless of market direction
• Uses shorting to reduce long exposure (typically 100% long and 100% short)
• Aims to have little or no exposure to overall market risk

LONG/SHORT HEDGED

• Seeks equity-like returns with less risk
• Uses disproportionate long/short position ranges, typically with a long bias (100% long and 70%-80% short, for example)
• Aims to have a reduced exposure to overall market risk

130/30

• Seeks to increase returns relative to a market or benchmark
• Uses shorting to pursue additional performance while controlling risk (typically 130% long and 30% short)

The strategies you see above apply mainly to equities and you can use them when you wish to hedge your equity portfolio. However, there are also other methods, using futures contracts, to hedge your portfolio, even if that consists of a basket of other futures contracts.

The 6 Best Ways to Hedge your Portfolio:

The most popular are:

• beta adjustment (we have discusses this in our first post)
• cash “equitization”
• long/short strategies
• tactical rotation
• conditional re-balancing
• portable alpha strategies

Let us introduce you to these concepts one by one:

BETA ADJUSTMENT

Asset Managers often seek better returns by adjusting portfolio beta to reflect future market expectations. Therefore, an asset manager may decrease the portfolio’s beta in anticipation of a bear market, or increase portfolio’s beta in anticipation of a bull market.

We have extensively covered one example in our first post “Introduction to Portfolio “……..

CASH EQUITIZATION

Mutual funds typically offer investors the opportunity to add or withdraw funds on a daily basis. Because of this, asset managers are often called upon to deploy additions or fund withdrawals on short notice. Therefore they utilize futures as a temporary proxy for the addition or withdrawal of funds, for example they buy futures effectively to deploy additions of capital or sell futures to cover withdrawals.

LONG/SHORT STRATEGIES

One of the most common long/short strategies is known as “130/30”. The equity manager begins by distinguishing stocks that are expected to generate superior returns vs. those that are expected to generate inferior average returns. The manager buys the superior stocks with 130% of the fund’s AUM, funding the excess 30% long position by shorting/selling inferior stocks valued at 30% of AUM.

SECTOR ROTATION STRATEGIES

Equity asset managers will generally allocate their funds across stock market industry sectors and individual stocks. In many cases, they may conform the composition of the portfolio to match that of the benchmark or bogey. This strategy assures that the performance of the portfolio generally will parallel performance of the benchmark.

However, asset managers may subsequently re-allocate or rotate, portions of the portfolio amongst these various sectors in search of enhanced value.

CONDITIONAL REBALANCING

Traditional pension fund management strategies require investors to allocate funds among different asset classes such as stocks, bonds and “alternate” investments (e.g., real estate, commodities, etc). A typical mix may be approximately 60% in stocks, 30% in bonds and 10% in alternative investments. The mix may be determined based on investor return objectives, risk tolerance, investment horizon and other factors.

PORTABLE ALPHA

“Portable alpha” investment strategies have become quite popular during the past decade. This technique distinguishes total portfolio returns by reference to an alpha and a beta component. The beta component of those returns is tied to a general market benchmark, e.g., the S&P 500. Additional returns are generated by devoting a portion of one’s assets to another more ambitious trading strategy intended to generate a superior return over the base or benchmark “beta” return.

Portable alpha strategies are designed specifically in the hopes of achieving (alpha) returns in excess of the applicable benchmark (or beta) returns. Thus, there are two components of a portable alpha strategy: alpha and beta.

Beta is typically created with a passive buy-and-hold strategy using derivatives such as futures or over-the-counter swaps. Stock index futures have proven to be particularly useful vehicles for achieving those beta returns in the context of a portable alpha program.

Futures are traded on leverage, freeing a sizable portion of one’s assets for application to an alpha generating strategy. Alpha returns, in excess of prevailing short-term rates as often represented by LIBOR, are generated by applying some portion of one’s capital to an active trading strategy.

The 6 Best Ways to Hedge your Portfolio

That’s it … more or less!

You must keep in mind that when retail traders are initiating outright positions, i.e., they are either long or short and they carry huge risks in case their view is wrong, professionals focus on risk management and they are looking to hedge their positions!

If you would like to know more about how professional traders and hedge funds operate, Fotis Papatheofanous recently reviewed a complete training course from Anton Kreil which you can find here: Anton Kreils Instutrade Course

Fotis kindly waived his commission so you have the opportunity to access the course at a much reduced price (its still available as of today, but we do not know when it will end).If you have any comments on this article please leave them in the box below (they will not show straight away as each one is vetted to prevent spammers).

The 6 Best Ways to Hedge your Portfolio by Fotis Papatheofanous