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Build your own hedge fund
Hedge funds make money in up markets and down, but theyre closed to all but the very rich. You can use these ETFs to assemble your own.
By Timothy Middleton
Last weeks turbulence in Japanese stocks -- the Tokyo exchange closed briefly because of too many sell orders -- reminds investors that hedging risk can provide a better nights sleep.
Hedge funds, which are designed to produce investment profits regardless of whether the stock market is going up or down, have proliferated in recent years. But they still are closed to all except the very rich, and using traditional mutual funds to hedge is virtually impossible.
Enter a host of nontraditional mutual funds -- including exchange-traded funds, which you can buy and sell like stocks -- that give you the building blocks to construct your own hedging strategies.
I began thinking about hedging while planning a European vacation for the coming summer. The dollar has fallen 12.6% against the euro in the last three years, despite a recent rally. A new ETF, Euro Currency Trust (FXE, news, msgs), would allow me to buy euros today that I expect will be more costly by July.
And it has a growing number of cousins. There are two new ETFs that track the price of gold, another valuable portfolio hedge. And a commodity-based ETF is awaiting the approval of the Securities and Exchange Commission.
Vehicles like gold ETFs . . . give us an opportunity to make money for clients, whether the traditional stock and bond markets are cooperative or not, says Michael Martin, chief investment officer of Financial Advantage, a planning firm in Columbia, Md.
Related news and commentary on MSN Money
Mining a new marketplace
Heres a brief survey of this emerging marketplace.
Ready for the dollar's next dive
Euro Currency Trust began trading only last month. A single share of the ETF represents 100 euros; the price at midday last Thursday was $121.22.
Why own euros? If the value of the dollar goes down against the euro, the net asset value of this fund will go up by the same amount. The opposite is also true, so in the dollar rally over the last year, you could have lost 9.6% of your investment in this fund.
But the long-term trend in recent years has been for the dollar to weaken, mainly because of the huge U.S. current account deficit. Also, unlike mutual funds, this ETF (and all the others) can be sold short, meaning you could use this one to profit from strength in the dollar. Selling short involves borrowing shares from your broker and selling them, expecting to repay the loan with cheaper shares bought in the future.
Bullish on bullion
There are two gold ETFs, iShares Comex Gold (IAU, news, msgs) and StreetTracks Gold Trust (GLD, news, msgs), and they are interchangeable -- both do virtually the same thing. Each share represents one-tenth of an ounce of gold bullion. Last week, they were trading around $55.
The price of gold is up 30% in the last year. A number of factors have contributed to the rise, notably rising jewelry and investment demand in Asia, as well as more buying by the worlds central banks to boost their reserves. Global politics also play a role. Owning gold makes people feel more secure in troubled times, and right now Iran is pushing the world toward a confrontation over nuclear weapons.
Finally, gold is the ultimate hedge against paper currencies losing their value. One rule of thumb is that an ounce of it will buy a decent mans suit, which was as true in the age of George the Third as that of George the Bush.
Waiting for a commodity solution
There are mutual funds that give investors exposure to a broader range of commodities -- including gold, copper, platinum and oil. But the one ETF in this category, which tracks the Goldman Sachs commodity index and trades on overseas exchanges, hasnt yet been approved by the SEC.
And there is the rub. Last month the SEC ruled that gains from what are called total-return index swaps dont fit the definition of income that qualifies for exclusion from double taxation on fund profits -- taxes payable by the fund as well as by its shareholders. The biggest and most successful commodity fund, the Pimco Commodity Real Return Strategy (PCRDX), employs such swaps.
The swaps are relatively inexpensive, so the fund uses its cash to buy Treasury Inflation Protected Securities, one of Pimcos greatest strengths. The bond income raises total returns above the level of the index. Pimco has until this summer to devise a different strategy or to get the law changed, a course of action it has suggested it will pursue.
The Pimco fund has a rival in Oppenheimer Real Asset Fund (QRAAX), which doesnt use commodity swaps and is therefore unaffected by the SEC ruling. It tracks the Goldman Sachs Commodity Index, which is much more volatile than Pimcos benchmark. That volatility is easily avoided by using the Pimco fund, which I expect to work itself out of the SEC muddle.
Make friends with volatility
Profiting from the market's loss
Leveraged inverse index funds offer portfolios that deliver more than 100% of the opposite of the performance of given index. In other words, when the market goes down, these funds go up even more, and vice-versa. In the case of the most volatile widely used benchmark, the Nasdaq 100 ($NDX.X), the main offerings are Rydex Venture 100 (RYVNX) and ProFunds UltraShort OTC (USPIX).
Both are designed to go up twice as much as the Nasdaq 100 goes down, and vice versa.
This index usually makes multiple double-digit swings in a single year. Here's a smart strategy: If the leveraged portfolio goes up 20% (a 10% move in the index), you sell enough to bring your stake back to the original level. If it goes down 20%, you buy more.
We make volatility our friend, says Martin, who uses the strategy to wring profits out of even a sideways market.
This is the very opposite of a buy-and-hold investment. In 2004, for example, you would have taken profits in January, bought in March and again in August, and then harvested gains in October and again in November.
This strategy takes iron nerves, however. In a prolonged bear market you would have to buy more and more shares at lower and lower prices, and you could only do that if you had total confidence the market would rebound -- and if you could find the cash to make those purchases.
Most investors shun investments like these in favor of building a broadly diversified long-term portfolio. But if youre the type who likes to take a risk -- if youve ever had your hands on something you call mad money -- investments like these can be fun, assuming you make them in moderation.
In my own case, if the dollar continues to go up, I would lose money on my euro investment. But Europe is already hellishly expensive; whats a few dollars more?
At the time of publication Timothy Middleton didnt own any securities mentioned in this article.
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