A SHORT TREATISE ON HEDGING
Profiting from Short Mutual Funds
INTRODUCTION: In the last years of the greatest bull market of all time, a small number of mutual funds were created to profit from selling stock short. For most of two centuries of previous market history, short selling was a tool used only by wealthy investors and professional traders. The history of previous bear markets is replete with criticisms against the practice of short selling and its perpetrators. The literature describes attempts to ban short selling that were countered by strong arguments in its favor, claiming that short selling does not create bear markets but adds needed buyers to support weak markets.
With about 50 years of diverse mutual fund experience, and no taste for
shorting stocks, I have been eagerly exploring the various ways to use the short mutual funds for profits. To no great surprise, I have found a very large number of ways to use them in conjunction with index funds, equity funds of all types and bond funds of all types.
The web page of wow.bearmarketcentral.com lists about a dozen mutual funds that are active short sellers. One indication of the large bullish sentiment in the current 20 month bear market is the small amount of investor dollars in these 12 funds. Morningstar data shows that these funds hold a total of $860 million or less than 0.03% of US. stock fund total assets. The pages of GOLD-EAGLE have been filled with articles decrying the very small capitalization of all gold mining companies. Although small by some measures, the gold share values greatly exceed that of the short mutual funds.
The purpose of this writing is to demonstrate a number of important ways that I have used short funds for hedging. The examples use the performance of real mutual funds from major companies over the course of the 20 month bear market. These results are those that would have been achieved if owned between the dates listed. I give the types of funds involved in each example but do not disclose their names since I wish to stress the hedging variables so that they can be used by the reader for any other funds that he or she chooses.
BEAR MARKET PERFORMANCE: For most of the current bear market I have owned 4 short funds identified below as A, B, C, and D. Here is some pertinent bear market performance data for the short funds and market indices through 11/21/01.
Annualized Gain or Loss (%)
Fund/Index 3/24/00 - 11/21/01
Fund A 47.8
Fund B 29.3
Fund C 24.1
Fund D (from 6/19/) 39.3
A, B, C, D average 36.0
Nasdaq 100 -48.4
S&P500 -16.4
Wilshire 5000 -18.7
Index average -27.8
Two of the four short funds are unmanaged and are related to the reverse of major market indices. The other two are fully managed funds whose short positions are selected by the manager. I am very happy with my four short funds and their performance to date. I prefer to use these funds as a group to provide a well diversified short position. In the hedged portfolios
discussed below, the short position always consists of a portfolio using
equal dollar amounts of these four short funds.
With hindsight it appears that an investor could have bought any of these
short funds and held them through the market ups and downs. But in real time it would have been quite scary to have been 100% short through bear market rallies such as the recent one. The price chart of these funds are extremely volatile. Although the trend is still down and a buy and hold short investor would be in good shape at this juncture, every bear market eventually turns. That is why I have never seriously considered holding a 100% short position. In the examples given below, we use a range in short percentages (of the total) varying from 15% to 75% based on the expected volatility of the funds held long.
I sleep better at night when my short hedge position is less than the long
position unless it is hedging a very stable mix of stock and/or bond funds as
in several of our examples.
The various short mutual funds can be used singly or together to hedge
against any long stock or bond mutual fund position. From the historic data
above, the +36% return of the 4 short fund average would permit a 50% short position to show profits against the S&P500 or Wilshire 5000 indices but not against the Nasdaq. From my extensive use of hedging during this bear market, I have found a short percentage of 20 to 40% (of the total portfolio) to be usually quite effective.
BEAR MARKET HEDGES: To demonstrate the effect of varying percentages of short hedges, I have put together some real data for a variety of equity and bond mutual funds. I have had many real hedged positions using these and similar funds, but these fictional hedge examples are provided only for their broad educational value.
HEDGE #1 - We chose 2 Gold funds and 2 Real Estate (REIT) funds with good bear market performance. Here are the results when hedged with the 4 short fund average. From 3/24/00 through 11/21/01:
4 long fund avg. gain = 14%, 4 short fund avg. gain = 36%
Long Fund Percent 50% 70% 85%
Short Fund Percent 50 30 15
Annual Return % 25 20.6 17.3
HEDGE #2 - Three leading Health Care funds, plus 0 to 33% of MM funds, are hedged with the 4 short fund average. From 3/24/00 through 11/21/01:
long fund avg. gain = 22%, MM = 5.4%, 4 short fund avg. gain = 36%
Long Fund Percent 33.3% 60% 80%
MM Fund Percent 33.3 10 0
Short Fund Percent 33.3 30 20
Annual Return % 21.1 24.5 24.8
HEDGE #3 - Four top performing small cap value funds, diluted with 0 to 35% of MM funds and hedged with the four short fund average. From 3/24/00 through 11/21/01:
4 long fund avg. gain = 24.1%, MM = 5.4%, 4 short fund
avg. gain = 36%
Long Fund Percent 35% 40% 50%
MM Fund Percent 35 20 0
Short Fund Percent 30 40 50
Annual Return % 21.1 25.1 30.0
HEDGE # 4 - Two leading gold funds (as in #1) plus two long U.S. Treasury
bond funds are hedged with the 4 short fund average. From 3/24/00 through 11/21/01:
2 gold fund avg. gain = 9.8%, 2 bond fund avg. gain = 11.1%, 4 short fund
avg. = 36%
Gold Fund Percent 25% 30% 35%
Bond Fund Percent 25 30 35
Short Fund Percent 50 40 30
Annual Return % 23.2 20.7 18.1
HEDGE # 5 - Three intermediate government bond funds are hedged with the 4 short fund average. From 3/24/00 through 11/21/01:
3 bond fund avg. gain = 9.9, 4 short fund avg. gain = 36%
Bond Fund Percent 40% 55% 70%
Short Fund Percent 60 45 30
Annual Return % 25.5 21.6 17.7
HEDGE # 6 - Three superior convertible (junk) bond funds plus 0 - 35% MM
funds are hedged with the 4 short fund average. From 3/24/00
through 11/21/01:
3 bond average = 3.5%, MM funds = 5.4%, 4 short fund
average = 36%
Bond Fund Percent 35% 40% 50%
MM Fund Percent 35 20 0
Short Fund Percent 30 40 50
Annual Return % 13.9 16.9 19.7
HEDGE # 7 - Three very speculative ETF funds (traded as stocks) are hedged with the 4 short fund average. From 3/24/00 through 11/21/01:
3 ETC average loss = - 24.3%, 4 short fund average gain = 36%
Long ETF Percent 25% 35% 45%
Short Fund Percent 75 65 55
Annual Return % 21.0 14.9 8.9
DISCUSSION OF HEDGE EXAMPLES:
Readers of this article need only a good source of daily or weekly mutual
fund data to construct their own hedged portfolios. All the short funds have had significant price peaks at the market lows in March and September of this year. When the current bear market rally ends, stocks in general will fall in price and the bear funds will rise.
If an initial hedge venture uses limited amounts of capital, it can be started at any time in the on-going bear market. Once an investor gets a feel for the market action of the long and short components, greater resources can be added. With significant expertise, investors can consider changing the short ratio at significant market tops and bottoms. For example with an average ratio of 30% shorts,, shift assets so that the ratio of shorts will be 40% before an expected market decline and 20% before an expected market rise. Only serious experts in market timing should consider the use of this device.
Based on my own 3 years of experience with short funds, I highly recommend that any newcomer move slowly until sufficient experience has been obtained. Remember that the simulated examples cited here reflect only the past 20 months of market action and may have performed differently than short hedges created for other future time periods.
Disclaimer: There can be no assurance that future hedges will perform as
shown in the examples here or that they will be profitable. The writer
assumes no responsibility for any and all investments made by readers of this article. Nothing implied or explicit in this article should be construed as
investment advice.
Robert B. Gordon Sc.D.
Sun City West AZ
rgordon145@aol.com
November 24, 2001
