Personal Hedge Strategies

In April we started discussing ideas about how to create personal hedges utilizing various ETFs (and a few major stocks).  In light of the recent market turmoil, commodities volatility, and the ominous shadow of inflation, I again began playing with some of the hedge-friendly ETFs that we've compiled over the past year.  Let's take another look at this list and adjust it based on anything new we've learned in the past months.

The idea here is not to offer speculations about the future, but instead to create hedges against reasonably likely future events.

Some obvious factors to consider would include:

• Rising inflation; how do you protect your USD cash holdings
• Stock market volatility; potential for big or small corrections
• Commodity volatility; traditional safe havens of gold and precious metals suffering from speculative volatility
• Sluggish or falling residential and commercial real estate; homes, REITs and homebuilder stocks potentially not offering a haven from inflation
• Weakening USD; how much of one's portfolio should be concerned with strengthening foreign currencies

It would be most useful to use a table of ETFs and stocks along with descriptions of the factors they address (positive or negative correlations).  I'm not looking to create a numbers-based allocation yet--this would need to reflect each investor's specific goals and situation--but instead just a short list of candidate ETFs and stocks.

ETF Short List:

Ticker	Name	Factors
FDG	Fording Canadian Coal Trust	Offsets high oil prices
PWI	Prime West Energy Trust	Correlates to energy
XOM	Exxon Mobil Corp	Correlates to oil
E	ENISPA	Correlates to energy, exposes USD/EUR
PCU	Southern Copper Corp	Exposes high copper volatility
DSX	Diana Shipping Inc	(Recommended by an old reader?)
DUK	Duke Energy Corp	Correlates to energy
VZ	Verizon Communications	Telecom factor in globalization
T	AT&T Corp	Telecom factor in globalization
WY	Weyerhaeuser Co	Fiber commodity exposure
ADM	Archer Daniels Midland Co	Food commodity exposure
GLD	StreetTracks Gold Trust	Gold
OIH	Oil Service Holders Trust	Oil
DBC	DB Commodity Index Tracking Fund	Commodities
USO	United States Oil Fund	Oil
IAU	IShares Comex Gold Trust	Gold
BG	Bunge, Ltd	Consumer food processing
CRESY	Cresud, Inc	Consumer crops (Argentina)
ALEX	Alexander & Baldwin	Hawaii transport (some ag)

Comments

[astrid]

I remember OO brought up a couple of other agricultural plays in this thread:

http://patrick.net/wp/?p=214

"Somebody asked a couple threads back about agricultural play, here are some options.

BG - I personally consider this the best play (well, that’s why I am in), lowest P/S, P/E, great crop exposure.

CRESY - same thing as BG, *except* that it is an Argentina company with almost all its businesses in Argentina, higher P/S, slightly higher P/E, but believers think that the commercial/residential property on the books are seriously undervalued due to the peso devaluation and tarnished Argentina image.

ALEX - produces 70% of Hawaii’s sugar, higher P/E. However, here is the catch, ALEX is heavily exposed to Hawaii’s RE market, and sugar only accounts for a small part of its revenue.

ADM - considered the prime ethanol play rather than agr play, too high P/E IMHO, so the upside is quite fully priced in already. "

[randolfe]

I've updated the list with BG and CRESY. I have ruled out ALEX (but I'm open to debate). I will refine the list and figure out a correlation matrix in the coming days.

[randolfe]

I've ruled out CRESY, at least from a MVO perspective. We'll see if it fits into BLO later.

[randolfe]

How to invest in commodities through ETFs:

The easiest way to gain exposure to commodity asset classes are through a wide range of financial instruments, as opposed to directly investing in the commodities markets or taking physical deliver of commodity assets.

If you are a non-specialized investor the easiest way is to invest money in indices which track a group of commodities. These indices will have a set of governing rules and weightings. Many mutual funds invest via the commodity index market.

Indices

Goldman Sachs Commodity Index (GSCI), trade as futures on the CME. This index represents 24 commodities, most heavily weighted in energy at around 75%.

The Dow Jones AIG Commodity Indices are comprised of contracts on up to 20 commodities. The rules specify a weighting between 2% and 33%. DJC and variants.

RCT is the Rogers International Commodities Index. This contains 35 commodities.

Notes AND Baskets

Indices are a simple way to gain long-only exposure to commodities. Notes and baskets, however, are more tailored to sophisticated investors seeking to fine tune their portfolios. Notes often include bond-style coupon payments and can be sold short. Baskets do not necessary depend upon index tracking.

ETFs

Exchange Traded Funds (ETFs) are financial instruments which trade as index shares but track underlying commodities. These provide a mechanism for retail traders to directly participate in the commodity market by exposing themselves to commodity asset classes, however utilizing their existing brokerage and commission structure.

The most popular commodity ETFs are:

StreetTRACKS Gold Trust GLD

COMEX Gold Trust IAU

Other Alternatives

Other routes for gaining exposure to commodities include using hedge funds and buying direct equity shares in commodity producers. Examples of this might include:

XOM Exxon Mobil (Oil)
BP BP (Oil)
RDS Royal Dutch Shell (Oil)
RIO Rio Tinto, Ltd. (Integrated mining)
BHP BHP Billiton (Integrated mining)

[Fewlesh]

I feel it is dangerous to hedge too strongly with energy. Energy prices are set at the margins, and a good recession will send energy prices down, so energy stocks are going to correllate with the US stockmarket. Same with commodity stocks: they track the stock markets (ie, high Beta I think the term is)

Now gold bullion is a speculative asset that is a last resort flight to quality. It doesn't track the stock market in large corrections. It is too volatile on any short term window.

I think any hedging strategy has to put numbers on the risk senarios:
1) Energy -- it can only go so high, maybe another 50% before real pain starts to kick in
a) So, to hedge energy, take your entire energy budget per year (gas, utilities), and hedge 3? years worth of usage in a energy correlled fund (See southwest airlines).

2) USD Exposure -- Serious downside here. USD could easily go into freefall and lose 40-50% of it's purchasing power over a 5 year window (It pretty much has too over any extended period of time to rectify trade deficits, baring some sort of economic miracle like semiconductors or computers were to land on US shores-- hell I work in new tech, it could happen, probably not in the correct time frame).

I've found the best place to gain short term, low risk, USD currency hedge exposure (this may seem obvious, but I did some test investments over the last year, and in this latest big downturn, found a good winner):

Emerging market bonds -- Yielding assets that give exposure to currency fluctuations.

I learned the hard way (it was a small test experiments -- 1500 investment in Japan stocks, lost 500, Euro stocks, small gains), that emerging market stocks ARE not the way to gain currency hedge. I've kept my emerging market debt, as they have yielded well, and hedged USD drops quite well. (Tiny test investments -- Yuan, Real? (Brazil), and Euro's right now, but dumped foreign stock markets).

I went back and looked at this latest correction, and in the past and found that in the current export driven global economy, foreign currency up, stock market down. This is a conumdrum (like everything else), but I blame the China currency peg for creating an upside global economy.

There's definitely a tipping point where currency devaluation leads to stock market declines in a nasty positive feedback loop, but I feel the US is not near that threshold on the 6 month horizon.

I'm now pinning my research to look into the China currency peg. It's keeping everything up in the air right now. Understading it's unravelling, or the methods used to maintain it are critical for any strategy.

Stocks: I'm looking at exporters who derive a large fraction of their revenue and profit from selling overseas. These may be very good long-term USD hedging investments, as you gain producing assets with currency positive gains.

Fewlesh

[astrid]

I wouldn't touch the PRC stock market. The market is opaque and rife with corruption and sketchy accounting. Yet they have crazy high valuation...as if these bloated monsters could possibly go up further! I assume this is just as true for most of Asia.

[randolfe]

I am also concerned about a 30%+ devaluation of the USD. The big question is how long the global imbalances can persist. They've already hung on for much longer than anyone would have thought possible. While I don't think we're in a "new paradigm" allowing for permanently overvalued assets, I don't know how long it will take to unwind the dollar.

Fewlesh mentioned new tech. That isn't as far-fetched as it sounds, and Fewlesh would know. There is a lot of potential in multiple, unrelated areas. Bio-genetics, nanotech, new materials, new energy. Any of these alone could bloom into a full-on industry capable of backfilling the deficits.

As to China...I'm not so optimistic. I think they're playing a dangerous game with their peg. They have created a real catch-22 whereby they cannot afford to unwind the relationship except very very very slowly.