How to Protect Your Portfolio
April 3rd, 2008 | by admin |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."
