Keep playing defense!

by Wayne Ferbert on November 15th, 2012

We are always hedged. The last 12 months have not been a great time to be hedged. Bull markets don’t create profits for hedges. The hedges expire worthless. Your underlying is growing – but the hedges drag down the returns.
 
So, you can imagine, it has been a 12-month window of lagging the market because of the cost of the hedges. The temptation has been to reduce the hedges, or take steps to make them cost less. Maybe reduce your protection levels? That is the temptation after a 12-month bull run.
 
Don’t do it. When the market sends you those signals, that is the wrong time to panic and reduce your protections. Just make sure your hedges really meet your risk tolerance and move on. Changing your hedges to offer less protection now would be the wrong time.
 
Consider the recent market swoon. There is NOT universal agreement on why this market has trended down so strongly since the election. Some blame is placed on European economy, some on Israeli tensions, and some more still on the Fiscal Cliff. Many even just think the market has run too far in too short a time window. Some think the pending tax changes are causing selling pressure. Too many different reasons should make you nervous that the market will have a difficult time shaking off the doldrums.
 
All of this is just reason to hold tight on your hedges and don’t reduce your protections. One thing to consider – if you have options that are downside hedges that are set to expire in December, there is a good chance that they are way out of the money – at least if they were bought on US sectors/markets around 6-9 months ago they are.
 
Consider salvaging some of the value from them early. Sell them now and roll in to the June or September 2013 protections. We have been doing that for several clients and for our own positions. The modest spike in volatility along with the market decline in the last month has revived the value of these deep-out-of-the-money protections. Salvage that premium while it is still there.
 
One other unconventional way to play defense: roll some of your US stock market gains in to out-of-favor sectors or markets. If the world markets do swoon together, you should out-perform by being invested in the sectors that don’t have as far to fall. Why don’t they have as far to fall? Because they weren’t high fliers to begin with!
 
Areas to consider that will likely out-perform if a global market swoon occurs: financials, Emerging markets, China, and possibly energy. These groups have multiples on their earnings well below their historic highs. That should provide some cushion.
 
I am not recommending a whole-sale re-balance to these investment categories. But rolling around 5% of your portfolio out of the US winners and in to these categories should prove useful!
 


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