How to Hedge Core Portfolios Using ProShares UltraShort S&P500 (ETF) (NYSEARCA:SDS)

Everyone seems to be asking themselves the same question, how can I hedge myself in this market environment?  Not surprisingly, I have recently been approached by foundations, profit sharing plans, and pension plans who are looking to do exactly this, but the approach they are taking, although it is something that most people on Wall Street are familiar with, certainly seems much more tedious than it needs to be, it removes flexibility, and the complexities of the traditional approach to hedging portfolios make it very difficult to be nimble in a market environment that requires us all to make fast decisions from time to time.

I'm speaking directly to the technique of hedging a core portfolio with an options strategy.  My definition of a core portfolio is a portfolio of equities that are designed to be held and not sold, so core portfolios would need to be hedged from time to time in order to prevent losses during markets that are declining.  The foundations, profit sharing plans, and pension plans that approach me recently all had mandates of being invested in equities, so they did not have the luxury of just moving to cash like some smaller investors have.  The best way to hedge a portfolio against loss during a market decline is to just move to cash, but not everyone has that luxury.

For these institutions that approached me I presented them with an option to that rather cumbersome options hedging technique, and that was to use ETFs.

What I proposed to them was not initially well received, until I explained how efficient it was, and I don't think that it will be well received when I introduce it in this column either until I explain it.  My technique involves the use of leveraged ETFs, ones that most people perceive as carrying with them substantial degrees of risk, some houses on Wall Street won't even let their employees trade in those types of instruments, and the general perception in the media is that leveraged ETFs impose unnecessary risks and are more frequently used by traders than by investors.

I can't argue with some of that, because those instruments are great for trading the market as well, but my discussions with the institutions that approached me to help them hedge their portfolios was not from the standpoint of suggesting that they trade their core portfolios.  Far from it, those core portfolios are designed to be held with a mandate of being invested into equities, so trading was out of the question, yet I still offered than this technique that involves the use of leveraged ETFs.

Although core portfolios can come in all kinds of different shapes and sizes, and the underlying stocks could vary significantly, for sake of this discussion I'm going to simplify it and assume that the core portfolio is invested into the S&P 500 using SPY.  For example, assume that $100,000,000 is invested in SPY, and that satisfied the equity allocation requirements in the bylaws of those institutions.

Instead of using options techniques, which were the initial indications of interest of the institutions that approached me recently, I suggested to them a technique that would completely neutralize their portfolio when markets were in overbought conditions in a manner that was extremely efficient, and empowered flexibility in a keep it simple format.

I suggested to them that they use the inverse leveraged ETF for the S&P 500, SDS.  Their first reaction was the same, they all balked at the idea of using a leveraged inverse ETF in their core portfolio, but something remarkable happens when we use it in conjunction with a core portfolio like the ones they are mandated to hold.  We are able to completely neutralize the portfolios during periods of overbought market conditions by simply buying the leveraged inverse ETF, we can do it with a click of a button, it has exceptional liquidity so we can easily capture the position that we need when we need to do it, and the most important part is that we can accurately hedge our entire portfolio without skew.  Yes, we use this seemingly risky instrument to remove risk, and that was an eye opener to all of them.

Options techniques have a tremendous amount of skew, there may be multiple options techniques being used at the same time, complications exist based on the underlying stocks and the variables associated with options including perceived risks and volatility, and it's very hard sometimes to get out of them quickly, but none of that matters to our leveraged ETF approach.

In the example of $100,000,000 invested in SPY, all we would need to do to hedge that portfolio is to buy $50,000,000 of the leveraged inverse ETF, ProShares UltraShort S&P500 (ETF) (NYSEARCA:SDS).  By doing so we would completely neutralize the portfolio while allowing the core portfolio to remain invested.  When we do this when the market is in an overbought condition and the market turns down we prevent our core portfolio from losing money, we do it in direct proportion, and we achieve the objective of hedging our core portfolio without complication.  We can also get out of that hedge as quickly as we got in. 

Using this approach would not only keep the portfolio invested in those core assets, but it would also allow dividends to be realized as always, which in many cases is one of the main criteria in many of these portfolios.  Dividends will be retained, but during periods of overbought market conditions this approach can prevent core portfolios from losing when markets turn down, which they usually do after getting into overbought territory.

Clearly, anyone using this technique needs to have an ability to identify overbought market conditions, that's important, but using options to hedge core portfolios largely requires the same thing, all be it on an individual stock basis and not necessarily on a broader market basis.

Personally, I find it much easier to identify overbought market conditions than I do overbought individual stocks, so my suggestion to all of the institutions who approached me was not only to develop a portfolio that tracked the market, but also to engage this leveraged inverse ETF approach designed to hedge their portfolios when overbought market conditions surfaced.  That kept is simple.

The benefits are outstanding, and the approach can be used to shelter core portfolios against market decline, which is exactly what investors seem to want in today's market environment.