How to Beta Hedge

In my last post I reviewed the strategy of how reducing the beta can help protect if the market begins to move down*.  So how do you do it?

It’s actually quite easy.  You sell assets that have a high beta and buy assets that have a low beta.  This in turn lowers your portfolio’s beta as a whole and makes it less sensitive to market moves. 

High beta assets:

• Small Cap stocks
• Emerging Market stocks
• Real Estate stocks

Low beta assets:

• Large Cap stocks
• Developed Markets stocks
• Macro/Hedged Equity managers

I also mentioned in my last post the problems that selling presents and how beta hedging helps reduce or eliminate those:

• If and when do you get back in?  You are staying in the market, just in assets that are less sensitive to market moves.  Thus, is no decision about when to re-enter.
• Does being in cash compromise your long-term goals?  Not really.  By beta hedging within stocks you are simply just changing the composition of the growth side if the portfolio.  Sure you have a lower upside, but you also have a lower downside. 
• Is this a panic move?  I hate panic moves, but in this case it doesn’t matter.  You aren’t overhauling your portfolio, just lessening its sensitivity to the market.

I will say that lowering your portfolio’s beta is no panacea.  If your beta is .70 and the market is down 20% you are still 14%.  This might not be tolerable.  Thus, in my next post I will cover prudent ways to sell. 

*No investment strategy can guarantee a profit or protect from a loss in a declining market. 

Volatility Bothering You? Try Beta Hedging.

The market has certainly been all over the place the last few months.  Not surprisingly, investors started to liquidate positions.  Is this prudent?  Time will tell, but when an investor does sell it can bring up some issues:

• If and when do you get back in?
• Does being in cash compromise your long-term goals?
• Is this a panic move?

A potential solution that helps eliminate or at the very least reduces the above issues – beta hedging*.

Beta is how an investment or an entire portfolio moves relative to an index.  For this discussion we will use the S&P 500: 

• A beta of 1 indicates the investment(s) should move in line with the S&P 500. 
• Greater than 1 indicates the investment(s) should move more than the S&P 500.
• Less than 1 indicates the investment(s) should move less than the S&P 500.

For example, a stock portfolio has a beta of 1.20.  The S&P 500 goes down 10%.  That investor’s portfolio should be down around 12% given past movements of the investments relative to the S&P 500.  Using the same scenario, if a stock portfolio had a beta of .80 the portfolio should be down roughly 8%.

So by lowering your portfolio’s beta you can help shield it from moves down in the market.  In my next post I will outline how to do this without running into the issues mentioned above. 

*  No investment strategy can guarantee a profit or protect from a loss in a declining market.  Beta  assumes specific time periods being covered. 1 year, 3 year, 10 year.  Behavior of stocks will vary versus the Beta during unexpected shocks to the market

Getting Older <> A Crash in Asset Prices

Last week I wrote about trends in emerging markets.  This week I stumbled upon an article from The Economist that discusses the demographic challenges facing developed markets – an aging population.  This is problem facing many developed economies including the US, but Japan, Germany, and Italy in particular.

First it’s best to describe the basic assumption associated with age groups and asset purchasing.  In general, working aged people buy assets and retiring people sell assets.  The former pushes prices up and the latter pushes prices down.  The article has some research that substantiates this:

• A paper by Elod Takats for BIS looked at home prices in 22 advanced economies.  He found that a 1% increase in old-age dependency ration (old people/working age people) was associated with a .66% drop in real home prices.
• The San Francisco Fed found that there has been a high correlation between the ratio of Americans aged 40-49 and those aged 60-69 and the market’s P/E ratio.

To me this indicates there could be some serious problems facing asset markets in developed economies; however, I don’t think it spells certain doom:

• Markets have likely discounted this.
• Elderly people may wind up working longer.
• More liberal immigration laws can help lower the average age.
• Monetary and fiscal policies can help address the problem of an aging a population.

Ultimately I think an aging population will have an effect on asset markets; however, I don’t think it will be severe. 

Where is the US?  In the short-term we appear to be aging; however, by 2025 we should have a strong rebound in working-aged individuals.

Dividends are Good Depending on the Source

Dividend paying stocks are becoming very popular among investors.  The FT notes investors have been moving aggressively into dividend ETFs since July.

There are many reasons to like these kinds of stocks:

• They tend to be bigger companies that have strong balance sheets & diverse revenue streams
• Given the above, those companies should be less volatile than the overall market and provide some stability of the market moves down
• Relative to small cap equities and low yielding government bonds these companies are attractively valued
• From the middle to the end of a cyclical bull market cycle large caps typically perform the best  

The key when buying a dividend paying ETF or stock is that they meet the above criteria.  Just because a company pays a dividend doesn’t mean it’s financially strong.  The same goes when buying a dividend paying ETF; just because it has a high yield doesn’t mean you are getting quality.  Basically, looking only at the yield is a suckers bet.  If an ETF yields 6% but the value falls 20% than you still lose.

You need to know your Dividend ETFs.  What is the composition?  What are the screens?  How many stocks are in there?  What index do it track?  It is imperative you get those answers before you invest. 

Past Returns Can Get You Burned

Hedge fund manager John Paulson is no doubt a smart guy.  He made a lot of money shorting the subprime mortgage market in 2007 and 2008.  His large gains and the bet he made is even chronicled in the book The Greatest Trade Ever Made (and probably a few others).

Recently however, Paulson has not as much success.  His two largest hedge funds are down over 20% this year and he may soon have to start liquidating assets in order to meet the outflows.  If he starts selling the bulk of his investments it could cause the value of his remaining investments to fall, making matters worse.

Did Paulson make a great trade?  Absolutely.  It is also true that he has struggled as of late.  I cannot say for certain whether his initial trade was luck, or if Paulson is an unbelievably skilled trader who will eventually recover.   

The point is judging a manager based on one trade, good or bad, is probably not the best way to pick if you invest with him or her.  Investing money purely on past returns is a fool’s game.  You need to look at the process and whether or not it’s sustainable.