Thursday, August 16, 2007

Hedging – Now available in Canada

Hedging consist in protecting your portfolio by purchasing an asset which will be negatively correlated with your portfolio. Negatively correlated means that, when your portfolio goes up, the offsetting asset will go down and inversely. Up until recently, the only way to hedge was using options. For investors, it can get complicated and the leverage can be frightening. Horizon recently started offering a Bear ETF on the TSX60 index which for every 1% downside move on the index, theoretically the upside on the ETF should be 2%.

Lets suppose I am an retired investor needing income to live needing to protect myself against a market downturn. I own a diversified portfolio of income trusts yielding around 8%. My total portfolio is worth $200,000 and I am currently invested $100,000 in income trust and scared so I have accumulated $100,000 in cash yielding another 4.5% or so. I want to protect this income. What shall I do? Perhaps I should buy some Horizon BetaPro S&P/TSX 60 Bear Plus (HXD.TO) which if my portfolio goes down will rise and compensate for the capital loss.

The chart below uses the Barclay’s iUnits Income Trust Sector index Fund (XTR.TO) as a proxy for my portfolio and compares that to the HXD.TO from July 16, 2007 to last night. The Income Trust units (blue line) have been falling with the market while the Bear Plus fund has been going the opposite way.

Given that HXD is supposed to rise twice as much as the fall of the market, I would expect that buying ½ my portfolio’s worth or $50,000 would compensate for the portfolio’s capital loss. The chart below illustrates that scenario.

It also shows that for most of the time, I would have been losing money as I would be a winner only during the past 2 days earning a total capital gain return of $4,000 or 8% on the $50,000.

If you want to be a purist, you could calculate the exact amount that would have been needed to offset the long position in Income Trusts. That would be $36,000 for a $0 capital gain. That must mean that the income trust sector is not falling as fast as the market.

Since $36,000 is the zero capital gains amount for the period, any amount above $36,000 should be considered as a bear bet on the market. Using $50,000, we would actually have a $14,000 bet against the market.

Finally, what would have happened if we were very good at “market timing”. Then we would not have purchased the HXD.TO on July 16, 2007 but on July 23rd instead. The $50,000 HXD.TO bet would have provided a $11,000 capital gain or 22% on the $50,000.

If all investments were held for a period of one year, the total return on the $200,000 would be:

Income Trust Income ($100,000) $08,000
Cash Income ($50,000) $02,250
Hedged portfolio Capital Gain ($50,000) $11,000

Total Return $21,250 or 10.62%

Not bad for a very defensive strategy in a DOWN market.

The Word

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