Why Can’t Johnny Hedge?

So here we are in 2010 with a class of investors known as the Baby Boomers, or, as I prefer the “B-Generation”, who will be planning their retirements during one of the most volatile times in our economy and stock market. Many may be wondering if their final 10 years in the labor market will at last bring them some financial security. This will be the first generation for which many of them will enter retirement without the security of a pension.

Those of you in the B-Generation are at a crossroad. The cohorts behind you, Generation X, are not that far behind either. Many of you may have to come to terms with the fact that your portfolio will not be where it needs to be to sustain the same quality of life in retirement that you had been working hard to earn. You are asking “What can I really accomplish during the next 10 years? The assets that I have I need to keep safe, but I also have to accumulate more. How do I go about doing this when investing has become so risky?”

It’s not that you’ve done anything wrong with the way you invest. You’ve been pushed into the classic long-bias investment model by the government’s market regulators. You see, with the traditional 401(k) or other defined contribution retirement accounts long-bias is the only model available, and mutual funds are the dominant products. This investment approach was suitable for most until about ten years ago. Since then, it’s the long only investor who has suffered the most during this decade’s two bear markets and they remain the most vulnerable to systemic risk, the losses caused by forces that are external to the portfolio.

The investment landscape has changed. During this past decade, trading in the U.S. equity markets, and the international markets as well, bifurcated between two types of investors: The professional traders and the wannabes known as the retail day trader who use the combination of the mechanics of moving averages and buy-sell volume; and a class of money managers known as “hedge funds” whose main mission is to earn a positive return for their clients no matter the direction of the market. Their abilities to rapidly deploy hedging techniques to reduce or even ignore the risks inherent in a long only portfolio have led to unusual spurts of volatility. Ten years ago, a decline of 8% to 10% in a single stock would occur over weeks or months; now it happens during a single trading session. This volatility is embraced by the professionals but frightens the long only investor causing him and her to respond irrationally with their investment decisions, usually by selling low.

Applying hedge fund techniques to the ordinary retail retirement account seems to be the logical way to stabilize returns. Unfortunately, SEC regulations restrict using a hedge fund platform to high net worth investors making at least $200,000 in annual income. If you are not part of this class what alternatives can you employ to reduce some of your long only exposure?

Below is a sampling of the more common hedging strategies used by hedge funds and their average returns for the last four years 2006-2009 (extracted from BarclayHedge.com)

-Long-Short: Average 4.63%, Standard deviation: 11.4% 
-Short Bias: Average 5.90%, Standard deviation: 25.5% 
-Multi-Strategies: Average 7.80%, Standard deviation: 18.5% 
-Market Neutral: Average 2.1%, Standard deviation: 2.9% 
-S&P 500: Average 2.7%, Standard deviation: 28.1%

The short bias and the S&P 500 were the most volatile platforms; the short bias outperformed the S&P. 
The market neutral was the least volatile but had the lowest return; so why bother with this technique, keep your money in a government bond fund instead. 
Long-short was in the middle of returns, better than the S&P 500 with much less volatility. 
The multi-strategy was the best performing with moderate volatility, though less than the S&P (this is a flex-strategy using a combination of hedging techniques)

Of these techniques, which are available to the retail investor?

-Long-short mutual funds and a handful of ETFs 
-Short bias ETFs, many with 2x and 3x leverage 
-Market neutral mutual funds/ just a few ETFs

But, these may not be available in the common 401(k) or comparable direct contribution plan platform. This is sad because it is now necessary, so you may have to raise this concern with your 401(k) administrator or write to your congress person and push them to approve pending regulations that will give ordinary retail investors access to hedge fund platforms. Good luck with either. You can also push your administrator to modify the plan to allow in-service withdrawals that can be transferred to an IRA account.

The IRA is more accommodating. Though you can’t short stocks due to margin restrictions, you can purchase short bias ETFs as well as long-short and market neutral funds. Also, you can purchase put options against your long positions in the account.

Until there is a wider array of hedging techniques become available to the retail investor, particularly for their retirement accounts, one would have to consider not being involved in the equity markets at all because having long only investment risk is financial suicide, even with proper diversification.

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