The Best Options for Hedging Your Portfolio After Recent Gains (DEF, XLP, XLU, SHY, HSGFX, SDS, DOG, UUP, VXZ)

After the 13% rally in the S&P 500 over the past 2 months many investors are wondering if they should hedge a portion of their portfolio. Many think quantitative easing and any political shift (both occurring in early November) are already priced into the markets. If that is indeed the case, it might be wise to hedge a portion of your portfolio through at least November until we can see what the elections and Ben Bernake have in store. If you make the decision to hedge there are many products out there, however all are not created equal and some should have never been created in the first place. Below I go through some good hedges, some ‘so-so' products, and some that should be avoided. The ‘Good' Hedge products: Consumer Staples Select SPDR ETF XLP. This ETF is a collection of defensive, stable, mostly recession proof businesses with a very low entry fee (expense ratio is 0.22%). Top holdings include Altria MO, Coke KO, Kraft KFT, Pepsi PEP, and Wal-Mart WMT. This ETF will most likely go down in a market swoon, but much less than the broad market. In 2008 for instance the ETF only lost 12% of its value vs. 37% for the general market. And if the market continues to go up, no worries, you own quality equities that will appreciate over time (although they will usually lag in strong up markets). Utilities Select SPDR ETF XLU. This ETF is a collection of utility stocks also with a 0.22% expense ratio. Like XLP, XLU is composed of defensive equities that will outperform in a down market, and under perform in most strong up markets. In 2008 it outperformed versus the broad market(down 26% vs. 37% for the S&P 500). In addition, this sector ETF boasts a 4.1% yield, double the S&P 500. Ishares 1-3 Year Treasury Bond ETF SHY. This ETF is simply a collection of very short term treasury bills. The yield is currently 1.2%, which is well above most money markets and savings accounts, while the expense ratio is a low 0.15%. In 2009 when interest rates moved up substantially the ETF had only a modest 0.4% loss for the year, and 2010 year to date the fund is up 2.9%. If interest rates go up and/or the equity markets crash this fund should not hurt you. Hussman Strategic Growth Fund (HSGFX). This mutual is unique. It holds many individual equities long and based on market valuation/trends it will hedge 0-100% of the portfolio. Currently it is 100% hedged using broad market indexes so the only return on the fund would be the difference of return between the market and the individual equities held. Completely uncorrelated with the market and fine to hold as a long term hedge. Only down year since 2000(inception) was 2008 with a modest 9% loss. The ‘So-So' Hedge Products: Claymore/Sabient Defensive Equity ETF DEF. This ETF is unique in that the index that it tracks attempts to hold the securities (given certain minimum criteria) that have recently performed well during market downturns. It then rebalances quarterly to replace with new securities that performed well in the more recent time period. Track record is ok during market downturns, but it does tend to buy those securities that have outperformed ALREADY, and with a 0.65% price tag dollars are probably best used elsewhere. PowerShares US Dollar Bullish Index ETF UUP. This is an ETF which tracks the performance of the US Dollar versus a basket of foreign currencies. Recently it has been the case that a falling US dollar helps US Equities, Foreign Equities, and commodities, with the reverse also true. If you feel the dollars' drop due to quantitative easing has been overdone this is a fair way to hedge securities that benefit from a falling dollar. It has a 0.58% expense ratio, but if held long enough the ‘cost' of rolling futures contracts takes its toll on performance. This is best used in the short to intermediate time frame. IPath S&P 500 VIX Mid Term ETF VXZ. This ETN tracks (through indirect rolling futures contracts) the volatility of the S&P 500 in the mid term (4th-7th month out). Almost always as the markets trade down volatility increases. If that were to happen this ETN would perform well and produce nice offsetting gains. For instance, from April 20th 2010 through July 2nd 2010, while the S&P 500 was down 15% VXZ was up about 46%. The big downside to this product is time as you cannot hold this indefinitely. One must guess right and guess right within a matter of months, for if held long term the rolling of the futures contracts will erode returns. The ‘Bad' Hedges: ProShares UltraShort S&P 500 ETF SDS. The ETF attempts to return 2x the inverse of the performance of the S&P 500. Sounds good, but not so fast. The product is forced to roll futures and this construction erodes long term performance at an alarming rate. In 2008 for instance while the S&P 500 was down 37%, this ETF was only up 15% (less than half 1x the inverse). The longer this product is held, the worse it performs (even if you guess right on a market downturn). Best to avoid the product unless you are looking to trade in a matter of days. The hefty 0.91% fee doesn't help either. ProShares Short Dow 30 ETF DOG. ETF which attempts to track the inverse of the return of the DOW. Again this product has the same problem as all inverse ETFs, although to a lesser extent compared to leveraged products like SDS. Also best to avoid this product (and its hefty 0.95% management fee) unless you are only looking to hedge for a short time period (days or weeks). Happy hedging!