Five easy hedges

PORTFOLIO POINT: There are several ways investors can prevent the value of their portfolio being eroded.

As the ASX 200 meanders around its post-GFC high, it's worth looking at how investors can protect themselves against another tumble in equity markets.

Whether your concern is a sovereign debt default in the Eurozone, a double-dip recession in the US or the bursting of an asset bubble in China, the end result could be significant erosion in value of your investments.

In my role as a hedge fund manager, I use several techniques to prevent losses on the fund’s positions. Many of these can also be adapted to protect an entire portfolio. Here are some of the more common ways that investors can achieve this.

1: Sell some or all of any profitable holding

Sounds simple, doesn't it? Yet psychologically many investors find exiting a position far more difficult than entering it. My rule of thumb is that if a stock has performed much better than you expected, sell an amount at least equivalent to your original investment and put it in the bank.

Providing you do bank the money, this is the most watertight solution of all. Unfortunately for many investors, this could also trigger a capital gains tax event and greatly reduce if not completely remove your exposure to any upside, which also makes this option the least popular.

2: Put in place rigorous stop loss rules

Even the best investors make mistakes at times. When you are convinced of a company’s potential and it just keeps moving the wrong way it’s not unusual for investors to say to themselves either:

• “The market doesn't understand what's really going on" (Unlikely).
• "I'll buy more and average down'" (Which is a near-guaranteed path to further losses).
• "I'll put this one in the bottom drawer until it comes good" (The point at which bad short-term investments become bad long-term investments).

Stop losses at a set discount to the entry price – say 15% (which we use) – are a valuable tool because they remove the emotion from admitting an investment has gone bad. You can discuss setting these with your full service broker or set them manually with your online broker where in most cases it will only cost you as much as it costs to execute the trade.

One of the downsides of stop-losses is that they require careful and constant monitoring. Going away on holiday with a series of stop-losses you decided on months ago is not a good idea. Selling prices you were happy with in January may no longer apply. The size of the discount at which one sets a stop loss really depends on each individual's tolerance for risk, but as mentioned, we find 15% works well to avoid catastrophe.

3: Put options and individual shares

Buying an option gives you the right but not the obligation to buy or sell a security at a specified price at a set time in the future (this is different from selling or “writing” options, which are best left to the professionals). There are two types of options: puts and calls. A call is where one has the right to purchase a stock at a set price and by a set time in the future. A put, on the other hand, gives one the right to sell a stock at a set price at a point in the future.

At a cost of about 1% a month, an investor can dramatically reduce the risk associated with owning shares in a particular company. The price of this protection can fluctuate depending on a variety of factors, including when the option will expire, general market volatility and the difference between the actual price of the security and the options strike price (the agreed price at which the transaction will take place).

For example, let’s say you hold a large position in Telstra (TLS) and are concerned about an unfavourable NBN ruling in coming months. You could choose to buy a put option that gave you the right to sell your holdings in Telstra at $3.05 in three months’ time. If Telstra is trading above $3.05 at the end of three months you are not forced to sell your holdings, you can simply let the option expire and your losses are limited to the premium you paid for the option.

However if, for example, you take out another put option in the following three months and an unfavourable ruling regarding the NBN does eventuate and the share price plunges to $2.50, you have limited your losses on this investment to $3.05 a share minus the premium paid for the put option. Importantly, ASX traded options are usually only limited to the biggest 50 or 60 stocks in the index, meaning you cannot use this for the small and medium-sized companies in your portfolio.

4: Put options over the entire index

In the same way in which the ASX provides option contracts over individual shares, investors can also access put options over entire indices, such as the ASX 200. Many long-term investors build up broad portfolios of shares which, whether they like it or not, generally track the same movements as the index.

If an investor with such a portfolio became nervous about the short-term outlook for the market and did not want to trigger CGT liabilities, they may choose to buy insurance in the form of index puts. These may be set at a level below which the investor is not prepared to wear any further losses: say 15–20% below where it is now. In fact, the former chief executive of BT, Chris Corrigan, did just this with the company's managed funds in the lead up to the 1987 sharemarket crash, thereby avoiding the losses suffered by so many investors.

Like puts over individual shares, the price of protection fluctuates according to a number of factors including when the option will expire, general market volatility and the difference between where the index is and where the strike is. Again, these forms of insurance usually start at about 1% a month so if you were to develop a strategy of rolling index puts out to December 2010 it may cost as much as 10% of your portfolio’s current value, perhaps more.

For this reason, they are only taken out by investors with a firm conviction about the market’s direction. Put options can be complex beasts and should only be taken out after careful consideration by investors prepared to put in the work and monitor them closely. However, in the case of a broad market selloff it will also allow those investors to weather unwelcome volatility without triggering a CGT event.

5: Short selling

Banned in October 2008 and mostly thought of as the sole domain of sophisticated hedge funds, many brokers now offer clients the ability to hedge long positions in their portfolios with offsetting shorts, which are again, mainly available over the biggest stocks in the index.

Say a longer-term investor has owned both NAB and CBA shares for some time, and while being nervous about the overall market, does not want to sell these stocks for CGT reasons. At a cost of often not much more than 1% per annum (for top 50 shares), an investor could short sell the banks he she doesn't own – say, ANZ and Westpac – as an effective hedge where the underperformance of one position is counterbalanced by the outperformance of another.

However, this strategy is not infallible. It could come undone if, say, the share prices of ANZ and Westpac dramatically outperform those of both the NAB and CBA. Assuming all the big banks move up and down together (which historically has been the case), then the risk of overall loss from this hedging technique is quite low.

The hedging techniques described here were indeed once the sole domain of hedge funds and other professional market participants; now, however, they're available to most investors. When used to hedge underlying physical holdings, either short or long term, they can substantially reduce both single investment and portfolio volatility.

Never forget, though, that the best way to avoid losses is by not making bad investments in the first place!

Tom Elliott, managing director of MM&E Capital, may have interests in any of the stocks mentioned.