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Sunday, November 6, 2011

Hedge Your Portfolio

Source: http: Capital Pixel
Sometimes when I talk with potential clients about the fixed income portion of their portfolio, I find that they are thinking "cash" √† la money markets, etc.  They see cash as their defense against a falling market.

Me:  "Maybe you should consider the asset allocation model that has 50% in fixed income."
Them:  "I'm pretty much there.  I have 3 certificates of deposit (CDs) and 20% in money markets."

Ooops!  CDs and money markets are not what asset allocators mean when they say "fixed income."  Fixed income means bonds.  The huge difference is that, when yields fall, bond prices rise and money markets and CDs, etc. don't.

To see this clearly, take a look at  the "Callan Periodic Table of Investment Returns."  This table shows 20 years of returns, on an annual basis, for 9 asset classes, including the 2 we want to focus on - the S&P 500 and Barclay's Aggregate Bond Index.

The table shows there were 4 years where the S&P 500 (the light blue box in the table) dropped. The following table shows these returns along with the returns on the Barclay's Aggregate Bond Index (shown as the gray box in the table).

Year          S&P 500         BC Agg
2000             -9.11%          +11.63%
2001           -11.98%            +8.63%
2002           -22.10%          +10.26%
2008           -37.00%            +5.24%

Given the anemic yields of CDs and money markets today, the hedging property of bonds is obvious.  It's worth noting that an even more effective hedge in down markets would be U.S. Treasury notes and bonds, but they could be costly in a rising rate environment - there's no free lunch here!

To bring bonds into a portfolio on a cost effective basis has never been easier.  The AGG is the most widely-traded bond exchange traded fund, and it has a management fee of .22%.  It pays to also check with your broker.  For example, Schwab offers SCHZ which tracks the same index, has a management fee of .1%, and is commission free.

If more hedging is desired, long-term put options (LEAPS) could be considered.  These were discussed previously.

Disclosure:  This post is intended for educational purposes.  Investors should do their own research or consult with an advisor before making investment decisions.  I own the exchange traded funds mentioned.

2 comments:

  1. To add to Robert's excellent post, bonds have a very low correlation to stocks which is excellent for diversification.

    ReplyDelete
  2. re: MC The low correlation is key especially in today's world where many other asset classes appear to be considerably more correlated than in the past!

    ReplyDelete