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I was recently asked by a reader (thanks Edwin) about my take on using a hedging strategy in a dividend investing portfolio. Although I have never done any true hedging (other than covered calls) in my dividend growth portfolio, it has been a huge topic of discussion from many financial pundits as a way to help limit the downside with a sliding portfolio. I did some research on it and wanted to provide a quick overview here, and provide my take on it.[ad#tdg-embedded]
The intention of hedging is to offset the downside risk in a portfolio through the purchase of an asset that will reward you if your portfolio goes the other way than you intended. This definition from Investopedia really sums it up best:
The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesn’t prevent a negative event from happening, but if it does happen and you’re properly hedged, the impact of the event is reduced.
Edwin’s suggestion was that an investor could hold 75% of their portfolio in dividend growth stocks and then purchase an exchange-traded fund that shorts the market using 3x leverage. The intention is that when the market tanks, you reap the gains three-fold. There are other types of hedging, such as using puts or covered calls to limit your downside. As I was doing some research on the topic, I could not find any definitive evidence that hedging was a good or bad strategy. I had to make my own call, and came up with the following two reasons that hedging using leveraged short ETFs are not for me:
1. I am a long-term Investor
My viewpoint is that over long periods of time (10+ or even more years) the market goes up more than it goes down. As such, I see portfolio hedging as a short-term strategy that simply helps to manage an investors emotional reactions when the market is going down. I have said it before, unless you truly understand your risk profile then you are prone to make rash portfolio decisions. If you are really comfortable with your asset allocation, then you should let it do its work over the long term.
2. Hedging can be Expensive
Buying portfolio insurance can be expensive. For example, the ProSharesUltraShort Russell 2000 (TWM) has an expense ratio of 0.95%. If the market is going up and this fund is working against you, then that additional MER will continue to erode the value of your portfolio. As a long-term investor (see above), my pontification is that the market will rise over long periods of time so why pay these additional fees.
This being said, I have been know to hedge using covered calls from time to time if the numbers look good. I therefore cannot say that I will never hedge, I just doubt I will hedge using a shorting strategy. The costs and the short-term focus simply go against my portfolio strategy.