How (and When) to use Sector ETFs to Hedge

Posted on October 14th, 2011

In our new book, Buy & Hedge: The Five Iron Rules for Investing Over the Long-Term, Jay Pestrichelli and I advocate the occasional use of sector hedges. A sector hedge is when you pair a hedge of a sector ETF to a stock you own in that same sector. You do this instead of building a hedge on the specific stock. Always remember Iron Rule No. 1 of Buy & Hedge: Hedge Every Investment.

But when is a sector hedge a better technique than a hedge on the specific stock? The answer is: It usually never is. Then why do we occasionally hedge using a sector hedge? In our book, the example we use is when the hedge of the specific stock is just too expensive compared to the hedge of the more diversified sector.

But sector hedges can be very useful for another type of stock: the deep value stock. In particular, this technique can be useful for the value stock that has underperformed its own sector. If the value stock you like has underperformed its own sector for both the last six months and the last 12 months, then using the sector ETF as the hedge can be an effective way to go. You should feel even more confident about the sector ETF hedge if the stock and the sector ETF have a reasonably high long-term correlation (>.75) for the last three years – despite the recent performance divergence.

Let’s look at an example in a sector that a lot of folks really like these days: consumer defensive stocks (sometimes called consumer staples). This sector has been very popular in the market because of the market and economic malaise. Defensive stocks are always popular in these kinds of conditions. As a result, the sector has had a nice run. It is hard to find value investments in sectors that have had such a nice run-up.

But one company that had underperformed the sector that I am watching is Safeway (SWY). I don’t currently own any but I am struggling to understand the stock underperformance of the companies that retail the single largest Consumer Staple (food). Many of the food retailers/grocers are underperforming the consumer staples sector – and Safeway is no exception. And Morningstar tends to agree as they currently have a fair value price of $24 (currently trading at $17.62). Morningstar has a four-star rating on the stock.

So, if you want to be long a Consumer Staple that hasn’t already had its run up, Safeway is an option. It has a 52-week range of $15.93 to $25.43. So, at $17.62, it is still closer to the 52-week low than it is the 52-week mid-point. And the Consumer Staples sector is up about 8% in the last year while SWY is down 17%. In the last six months, Consumer Staples are flat while SWY is down 27%. This stock has definitely underperformed its sector and is a candidate for a sector hedge.

So, let’s examine the potential trade here: You buy 1,000 shares of Safeway at $17.62. And you build a hedge on SWY using a Consumer Staples ETF. I like the (XLP): Consumer Staples Select Sector SPDR ETF. The XLP is trading at $30.77 today. So, it takes roughly about 600 shares of the XLP to equal the $17,620 worth of SWY we purchased. That means we’ll want to buy a hedge on the XLP for 600 shares.

The XLP has put options that trade on it. Our sector hedge here would be six contracts on the XLP. I like to purchase the protection for staggered months. Let’s look at three contracts for the December month and three contracts for the March month. The December puts with $28 strike are priced at $0.30. And the March $28 put strike is priced at about $0.78. I like both these spots. They provide you with solid protection to the downside in the sector of about 10% downside. And the cost is roughly 6% annualized to buy this protection. Additionally, if you wanted, you could sell covered calls on your SWY position to help offset the cost of the hedge.

When buying a tried and true company like SWY that is a value play and underperforming its sector, this hedging strategy using the sector ETF can be a smart way to hedge at a lower cost. Don’t ever forget that hedging using the sector ETF still leaves you exposed to company-specific risk for which you are not hedged. This strategy is best used for larger companies with a sound business model and an entrenched client base. Small cap stocks with short-track records are rarely candidates for this technique. But bellwether value stocks can be hedged nicely with this technique.

I hope this article helps you to understand alternative ways to look at hedging your portfolio.


Posted in ETF Hedges    Tagged with ETFs; hedges


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