For the past eight years since the recession in 2008/2009, the stock market has experienced a strong bull run, reaching record highs as it keeps increasing in value. Since March 2009, the Dow Jones Industrial Average has increased 150 per cent, the S&P 500 by 200 per cent, and the NASDAQ by 250 per cent.

Because of this almost decade-long upward trend, many economists and financial advisors believe that there will be a market correction resulting in decreased market value in the coming years.

In everyday life, we make investments to secure and better our future. Whether in the form of education, buying a car, or buying a house, we spend a considerable amount of time and money on them.

Like all things of this nature, we need to do our best to insure them, that is, protect them from future damage. While you can go out and purchase home or car insurance, how can you “insure” your financial investments against a possible downturn?

The answer: Hedging.

Hedging is the practice of strategically using instruments in the financial market to mitigate your portfolio’s exposure to adverse price movements. By using various instruments you can seek to reduce short-term losses on your portfolio and help preserve your investments.

In essence, hedging can be looked at as insuring your investment portfolio against market volatility. When hedging your portfolio, one typically uses about 5-15 per cent of your portfolio’s value to invest in the chosen instruments for portfolio stability and to minimise losses, not to increase profit.

There are numerous ways of achieving this, and I would like to concentrate on using inverse-ETFs as a hedging tool.

WHAT IS AN ETF?

An ETF or Exchange Traded Fund is essentially a basket of goods packaged neatly into a single security that is traded on the stock exchange similar to common stock.

Different ETFs comprise different baskets of goods, ranging from a specific sector or commodity to an entire index. If, for example, you wanted to track the performance of the NASDAQ, the PowerShares QQQ Trust, Series 1 (ETF), commonly known as QQQ, would be a common solution. Both the NASDAQ and QQQ move in tandem; if the NASDAQ increases in value, so does QQQ and vice-versa.

USING ETFS TO HEDGE

If you want to track an index such as the NASDAQ you can buy QQQ, if you wanted to track the DOW Jones you could buy DIA, but what if you wanted to use ETFs to hedge your portfolio?

While some EFTs move with the specific index, there are many that do just the opposite. Inverse-ETFs move opposite to the index or commodity that they are linked to. Instead of their underlying assets being tied to the market or commodity, inverse-ETFs invest in derivatives that either take a long or short position on that market/commodity.

When you take a long position, you essentially own stock which you believe can be sold at a higher price in the future. When you take a short position, however, you essentially sell shares that you do not own in the hopes that prices will decrease in the future, thereby owing the same number of shares but at a lower price.

Inverse ETFs take a short position on their underlying assets. If you buy an inverse-ETF linked to the price of gold, for example, and the actual price of gold falls, your ETF increases in value. If, however, the actual price increases, your ETF decreases in value.

As previously stated, the purpose of hedging with inverse-ETFs is not to increase the net profit of your portfolio, but to try and make back some of the value lost in the event of a price depreciation.

With a well-diversified portfolio divided into fixed-income securities and equities, a good hedging practice would be to take 5-10 per cent of your equities portfolio and invest into inversely related ETFs. By having this allocation for hedging, if the market continues to appreciate in value, your gains outweigh the losses invested into the inverse-ETFs; and if the market experiences volatility or decreases in value, causing a decrease in portfolio value, some of the losses will be offset by increased value of your ETFs.

Like life, nothing in investing is 100 per cent certain. Markets, at their core, perform based on the speculation of humans. Because of this, there is always the possibility of a swing in market trends and a sudden increase or decrease in the price of commodities due to our speculation.

While markets do correct themselves in the longrun, short-term losses could be significant and it could take years to rebuild your investments. However, by using instruments such as inverse-ETFs, you can “take out an insurance policy” on your portfolio and minimise short-term losses, and in the end maximise long-term stability and security.

Michael Ammar, relationship manager — Private Wealth Management at Stocks and Securities Ltd.