Using ETFs as Hedges and Speculations

A lot of discussion lately centers around an apparently growing feeling among many people that things are changing.  The is no shortage of uncertainty in today's economy, that much is for sure.  In threads I host on Patrick.net (a Bay Area real-estate focused blog), recurring topics of interest include the real-estate bubble, risks to the mortgage-backed security industry, overall credit risks, the US current account deficit, the weakness in the USD, oil and energy prices, and inflation (or deflation) risks.

What is one to do?  Can a reasonable person either hedge themselves or perhaps even speculate on the future in a responsible manner?  This discussion is about what exchange traded funds (ETFs) one might use, and how to use them responsibly.

For purposes of this discussion we'll follow these simple definitions, as they apply to an individual:

• Hedge:  A position which bets for or against an expected future trend or event which is uncertain.  The hedger wishes protect another position she holds -- probably an asset or cash flow position -- with the hedge.  Hedges need not make money to be considered effective; they need merely limit risk.
• Speculation:  A position which bets for or against an expected future trend or event which is uncertain.  The speculator will make money if they bet right.  Speculations always increase risk.

We have spent quite a bit of time on Patrick.net discussing if and how an individual can hedge against home prices, assuming a real-estate bubble.  We've discussed the use of Hedgelets from HedgeStreet.com, but there is a real liquidity issue with this market.  We've discussed using MACROs, a new instrument on the CME, but this market is brand new.  A lot of commenters offered up various configurations of ETFs which would create effective hedges.

By far the most commonly discussed ETF is a gold interest, GLD.  The proposition is that gold represents a commodity hedge against inflation which can be used by either an existing home owner wishing to hedge against a real-estate hard-landing (to protect their equity), or by a renter to protect against opportunity loss of further rises in home prices.

Another personal hedge, albeit a stylized extreme case, came up over beers last night with a collegue of mine:  hedging against rising gas prices.  Assume that one owns a big SUV and would like to keep driving it.  It should be possible to hedge that position by buying OIH, an oil-industry ETF.  Therefore, if oil goes down, you save money as your cash flows go out of your wallet at the pump.  If oil rises, you make money on your OIH position to help fuel your beast.

Then there's the prospect of speculation.  These same techniques can be employed to make directional bets on the future.  What I'm interested in generating in this thread is specific scenario propositions and configurations of ETFs which could serve as either hedges or speculations.

Comments

[randolfe]

Some ETF suggestions from an old thread on Patrick.net. By DeoVindice who was a macro-bear

FDG: Fording Canadian Coal Trust (USA)
(Public, NYSE:FDG)

PWI: PrimeWest Energy Trust (USA)
(Public, NYSE:PWI)

E: Eni S.p.A. (ADR)
(Public, NYSE:E)

PCU: Southern Copper Corporation (USA)
(Public, NYSE:PCU)

DSX: Diana Shipping Inc.
(Public, NYSE:DSX)

DUK: Duke Energy Corporation
(Public, NYSE:DUK)

VZ: Verizon Communications
(Public, NYSE:VZ)

This mix gives me exposure to Coal, Nat Gas, Diversified energy production, Foreign currencies, Copper and other base metals, Silver, an indirect play on bulk shipped dry commodities, a play on the collapse of the communist system (Duk benefits as high income blue staters flee for protection) and VZ has a good yield, and is in a different type of commodity bidness. Afterall, Enron used to trade bandwidth like energy, so why not?

You could leave off DUK and VZ and have a true high yield fund. I like the added stability. You could swap in WY or even ADM if you want to be strict about it.

WY: Weyerhaeuser Company
(Public, NYSE:WY)

ADM: Archer Daniels Midland Company
(Public, NYSE:ADM)

[TN]

Is it possible to have a close to perfect hedge portfolio that preserves almost all value (minus the management fees) through almost all but the doomsday scenarios? Of course the corollary of the theoretically perfect hedge portfolio is that you would be sacrifcing all possibility of growth.

One method might be to find as many pairwise funds with historical highly negative correlations. Build mathematical models and sim various linear combination portfolio weightings with various price movements to see if you can get within acceptable tolerance levels.

[Fewlesh]

I found a fantastic hedge against dollars and metals today after working some stuff out.

Buy several tons of US pennies.

Here's the current cost of a penny in raw materials: $0.00727249887, that's 0.72 cents in todays dollars.

(assuming 97.5% zinc, and 2.5% copper)

It's a beautiful hedge. First off, it is complely liquid, as it is legal tender. Second, if things get bad, it can always be melted down for a profit (It may need to be shipped out of country first though).

Not that this is practical, but it's fun to think about saving all those pennies around the house.

Fewlesh.

[astrid]

Hee, you should put this meme out on the web. I can just see the loons in their bunker with MRIs and huge mountains of pennies.

What about utility companies and other companies with large fixed rate bonds? Would that be a good hedge against inflation?

[Peter P]

"One method might be to find as many pairwise funds with historical highly negative correlations. Build mathematical models and sim various linear combination portfolio weightings with various price movements to see if you can get within acceptable tolerance levels."

I did try to build a pairwise trading model. However, I got busy in other things.

One good thing about ETFs is that they are usually uptick-exempt so shorting is a little easier.

[Peter P]

"Not that this is practical, but it's fun to think about saving all those pennies around the house."

Is it legal?

[randolfe]

Fewlesh's idea is interesting. It may not be strictly legal (I think it is illegal to destroy any form of currency). But then again, is it considered destroying when you are preserving the economic value?

So the only problem I can see is the practicality, as Fewlwesh called it. In financial terms, this translates to storage-costs as applied to a commodity derivative bet. I suspect the real storage costs will be far greater than the value of the hedge, preventing any form of arbitrage.

Not that you couldn't sell this as a packaged plan to guys in bunkers with MREs. Just go on late-night radio shows hawking this along side the gold eagle coin guys.

[randolfe]

Peter P,

Would you be willing to share the pairwise work you did thus far? I'd be happy to put it into an organized fashion. My ambitious plan is to get a few candidate portfolios together based upon people's guesses about the future then track them to see how they hold up.

Also taking suggestions for any available simple web-based software that will do auto portfolio tracking (I already have a sharpe-ratio linear optimizer, but not a port-tracker/manager). I have both .NET and UNIX server platforms I can deploy and link here.

[Peter P]

"Would you be willing to share the pairwise work you did thus far? I'd be happy to put it into an organized fashion."

Sure, although they are very preliminary, if not downright primitive. I need to dig it up though.

Do we really need pairs? Won't a regular long-short portfolio work?

[Peter P]

"Also taking suggestions for any available simple web-based software that will do auto portfolio tracking (I already have a sharpe-ratio linear optimizer, but not a port-tracker/manager). I have both .NET and UNIX server platforms I can deploy and link here."

I used to go to www.riskgrades.com

They do not have an optimizer, but it is possible to perform what-if analysis.

If you want to build your own, where do you get affordable licensed data.

[randolfe]

They do not have an optimizer, but it is possible to perform what-if analysis.

If you want to build your own, where do you get affordable licensed data.

I have an optimizer, but it's Excel/VBA. I was going to port that to C# anyway. I also have a web-agent system that can pull daily market data from web sources (mainly google finance beta). Yahoo is too obscufated to be of use, but there is lots of free historical data there to populate for variances and such.

[Peter P]

"I also have a web-agent system that can pull daily market data from web sources (mainly google finance beta)."

Technically it may be violating some acceptable use policies though. It should not be too big a problem if the site is private, but IANAL. :)

BTW, what do you think about using Sortino ratio instead of Sharpe ratio? Many commodities have asymmetrical volatilities.

[astrid]

I know this is OT, but anyone looked into companies with large long term fixed price (or price fixed to wacked out indices like the CPI) contracts on fuel or commodities? There might be some value there not yet extracted by arbitragers.

[Peter P]

"I know this is OT, but anyone looked into companies with large long term fixed price (or price fixed to wacked out indices like the CPI) contracts on fuel or commodities? There might be some value there not yet extracted by arbitragers."

Some airlines hedge fuel costs.

The problem is that hedging can produce massive losses. Metallgesellschaft AG is an example.

Moreover, what is long-term?

[randolfe]

astrid,

It's the problem of "overhedging". When companies do lots of "operational hedging" -- that is they hedge cash or supply inputs against their future cash streams -- then you have a really hard time using that equity itself as a hedge. This is the classic debate as to why one should probably never hedge a foreign index (like EUREX) against the USD even though returns are in EUR. So many of the companies in the EUREX earn USD revenues that they already hedge you can end up overhedging and undoing the risk benefit.

[astrid]

I was thinking back to some early 70s contract cases, regarding production or demand contracts - I'm thinking at least 5 yrs. I assume major chemical/refining companies have this sort of contract in place. Depending on the language of their contracts and how they priced commodities in the contract, there might be room for arbitrage, or at least comparative advantage in their field to companies without these contracts.

I believe most US airlines sold their fuel contracts after 9/11, which left them completely unprepared for the recent runup in fuel prices.

I'm not sure what I propose is for us, even if there are economic values there. More of a theoretical brainstorming thing + bait in case there's an energy contract lawyer or energy sector analyst out there who is willing to share info.

[astrid]

What I'm thinking of is not hedging per se, but a jackpot scenario as the result of sub-optimal contract draft.

[randolfe]

I'm still looking for some reasonable (and free) web-based portfolio management source code. Sourceforge.net has some interesting stuff, but nothing that really will suit our purposes. Interestingly, Peter P, there is a project which specifically grabs, transforms and stores in a database Yahoo finance data. So much for EULAs.

(As I argue very often over at another blog -- TerraNova -- EULAs are often a house of cards that companies don't like to test in court. Many of EULA and ToS agreement has been held unenforceable by courts, so companies just like to use them as bully sticks, not as legal fodder.

[randolfe]

Fewlesh said:

I found a fantastic hedge against dollars and metals today after working some stuff out.

Buy several tons of US pennies.

Here's the current cost of a penny in raw materials: $0.00727249887, that's 0.72 cents in todays dollars.

Today's Financial Times (US Ed.), front page: High metal prices mean melting coins could start making cents

There are 160 pennies per pound, with a face value of USD 1.60. 97.5% zinc, 2.5% copper. At current prices 1 pound of pennies = USD 1.36. All it takes is a USD 0.25 per pound rise in zinc ($551 per ton) to see the intrinsic value of pennies exceed the face value. So, it is definitely possible.

I note that this analysis ignores the cost of melting, storage, and the sale transaction. However, at scale, pennies could become a commodity arbitrage opportunity. More likely, we'd see the "scrap hound" types in poor, inner-city areas (the guys who steal pipes from building basements) start removing pennies from circulation, even if purely on a psychological level (they don't perceive the hidden costs, only seek the immediate cash payoff).

My thinking is that, if this all occurs, the US Gov't would use it as an excuse to finally put the Penney, and probably the nickel too, out of their collective misery. I don't think they'd keep minting new pennies knowing they're all just being scrapped.

Another, more financial concern, is that the run up in zinc and copper are part of a bigger stand-off between hedge funds (which think commodity extractors have under invested based on prices) and producers (which think the hedge guys don't understand metals business cycles). My bets are with the guys who run the mines, not the hedge geniuses.

[Jimbo]

Storage costs on a ton of pennies is suprisingly small. A copper block a foot on each side is about one ton, so I can't imagine zinc to be much larger. You could just have twenty 100 pound sacks sitting in the corner of your garage.

But a ton is still only $3200. To really make this worthwhile you probably want 10 or 20 tons. Storage is a bit bigger of an issue there, but if you had a spare garage you could just put them all in there.

I can't imagine how you would convince a bank to give you 20 tons of pennies though. Maybe the US Mint would. They sell bags of coins like nickels, but always at a huge markup.

[TOLurker]

Too late, it is now apparently illegal to ship out more than $5.00 worth of American coins out of the U.S. I think someone in the government cottoned on to the fact that the coins intrinsic value exceeded their face value. Sort of like a U.S. "$20" gold coin!

[randolfe_]

Damn. We should have moved on it way back when we were talking about this stuff. Oh well, just goes to show blogging is 99% hot-air and 1% action.