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Thursday, October 29, 2009

James B Stewart of the WSJ Engages In A "Hedging Experiment" And It's A Bad One.

James B. Stewart writes the "Common Sense" column for the WSJ which is sometimes interesting but seldom particularly useful. He seems to give advice for trading based on this "system" but like most media personalities of this type never really gives a precise accounting of his buys and sells and thus of his success.

Generally his columns and decisions have some kind of logic. But this week's column on his "experiment" in hedging using pro shares inverse etfs is so ill informed as to be dangerous to individual investors. Thankfully he advises them to wait to see the results of his strategy before considering implementing it. One would have hoped that his broker would have followed the guidelines recently issued by FINRA with regards to warning investors about the use of short etfs. I have written about the perils of short etfs in previous posts.

Even the title is confusing he titles it "An Experiment in Taking More Risk" but then describes a hedging strategy designed to reduce risk.

my bolds, my comments in italics
An Experiment in Taking More Risk


The Dow Jones Industrial Average may have recently crossed 10000, but the Nasdaq Composite has remained stubbornly below my next selling threshold, 2200. While waiting for this milestone, which would mark a 75% gain for the Nasdaq since its March low, I've had time to explore options for reducing my exposure to the stock market. That has led me into new territory, at least for a relatively cautious

Strictly from a historical perspective, this market is overdue for a correction. As a result, I found myself examining the many offerings in the ProShares family of exchange-traded funds that let investors profit from market declines. I came away convinced that in unusual circumstances, some of these funds can play a useful role.
These short ETFs essentially offer a hedging tool and a way to profit from falls without having to sell short (selling borrowed shares in the expectation that the price will fall and they can be bought back at a lower price) or wade into options. I never short stocks or indexes because they carry the risk of unlimited loss. The ProShares ETFs I'm concerned with here don't sell short, either. They use derivatives, such as swaps (where two parties agree to exchange the returns on underlying investments). They may also add leverage to magnify gains, and losses. While options have fixed expiration dates, the ETFs offer the flexibility of selling whenever an investor chooses.

Well the above is missing alot of logic. If the investor is holding a portfolio of stocks and wishes to hedge all or part of the portfolio against drops in the overall market for any period more than one day, then the choice is obvious and it is not the short etfs. The direct hedge which is guaranteed to offset the index performance for the holding period is to short the relevant etf (SPY for instance in the case of the S+P 500).

While Stewart may be theoretically correct that there is potential for unlimited loss in a short position, that only holds for a naked short position when one does not own the underlying stock(or index). But that is clearly NOT the case when one combines a short position in the overall market with a portfolio of stocks. The short position will move one to one with the overall index rising in value when the market falls while the rest of the portfolio will decline in value. It is absolutely impossible to have exposure to "unlimited losses" when combining a long position in stocks with a short position of equal or smaller size in the overall index. That's why it's called a hedged portfolio Mr. Stewart. Short index + long stock portfolio = hedged position.
Mr. Stewart's vehicle of choice is an imperfect hedge. While the short etf position will move inversely to the overall index over whatever period the position is held the inverse etf is an imperfect hedge for any period longer than one day:

The ProShares short funds are designed to be the inverse of the relevant index; the leveraged ultra-short funds aim to be twice the inverse. So if the Standard & Poor's 500-stock index dropped 10%, the ProShares Short S&P500 would hope to gain 10%; the UltraShort S&P500, 20%. Losses, of course, are also magnified.
ProShares warns investors that it aims to have the funds' movements correspond to the inverse of the relevant market indicator on a daily basis. Over more time, the effects of compounding can (and generally will) dilute or enhance the results. For the second quarter, when the S&P 500 gained 15.93%, the Short S&P500 lost 16.03%. Year-to-date the total return for the S&P 500 is up 20.10%, but the short fund is down 22.63%.

No one should expect the funds to achieve a precise inverse correlation. Nor should they be long-term holdings. Given that the historical market trend is up, and that bear markets on average are much shorter than bull markets, they should be used only for short-term hedging strategies. And they should be monitored closely.
Except in rare cases, I can't see owning one of these. But as the Nasdaq creeps up, I decided to see if now is one of those times. I bought a modest position in the UltraShort S&P500 ETF as an experiment. I'm deliberately calling this an experiment, not a recommendation, and suggest conservative investors let me be the guinea pig. I'll keep you posted.

Mr. Stewart is cognizant of the shortcomings of this instrument (explained quite clearly on the proshares website) and still makes them his instrument of choice for short term hedging even though they will not give a precise inverse correlation.
Here is ytd data through Oct. 29

ytd sp 500 etf (spy) +19.65% inverse etf (SH) -22.81

The goal of hedging is to create a position that offsets exactly the change in value of the underlying position.

The hedge with the proshares short etf had an offsetting change in value that captured was -1.16 x (-19.65 vs +16.2%)the move in the underlying meaning it was not very good hedging vehicle . This is compared to a simple short of the spy etf which would produced the inverse of the move in the sp 500 exactly.

There is little reason not to think that Mr. Stewart's "hedging strategy" will turn out similarly.

So why use the etf and not a simple short in the spy. ?

The only possible reason would be lack of comfort with a margin account. But if the short margin position is matched by a long positin there is no possibility of "losing all your money" unless you unwind one position without unwinding the other.

In fact given the market of the last few days, if Stewart entered into his "experiment" on the day the article was published, the divergence between the changes in the value of the etf and that of the underlying value would be even greater. That is because the inverse etf is based on the daily move of the index and volatility is the enemy of hedging with the inverse etfs

href="">On their website Proshares explains the negative consequence of volatility for hedging with the inverse etfs:

When “10 + -10 = -1”
In a volatile market, compounding can result in longer-term returns that are less than the sum of the individual daily returns.
An investor who starts with $100 in an investment that rises 10% on one day and declines 10% the next would have $99, or a -1% return. This is less than the sum of the individual day returns, or 0%.

So I wish all the best to Mr. Stewart on his "experiment" but anyone that undertands hedging would know beforehand how this will work out. His hedging strategy will have "slippage" between the underlying and the hedge, shorting the sp 500 etf(spy) would not.

—James B. Stewart, a columnist for SmartMoney magazine and, writes weekly about his personal investing strategy. Unlike Dow Jones reporters, he may have positions in the stocks he writes about. For past columns, see:

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