Nov 14, 2016 | by Franck Cushner, CFP®
So far, we’ve discussed hedging on an asset-to-asset approach, using one asset with negatively correlated returns to offset losses in the other. This method of hedging, while on its own still imperfect, when taken in the context of a portfolio of multiple assets, improves the benefits of diversification. Diversification is investing in multiple assets to reduce the volatility (unpredictability) of a portfolio. The added benefit of diversifying with hedge instruments is that the negative correlations between assets reduce volatility in the overall portfolio’s performance more than non-correlated or positively-correlated investments.
Volatility of a portfolio is a result of the three things: the weights of each asset, the volatilities of each asset, and the correlation between assets. Assets with perfect positive correlation (equal to 1), will have a portfolio equal to the weighted average of volatility. If you keep the weights positive, let's say .5 and .5, whenever you have correlation less than 1, your volatility will be less than the weighted average. The lowest volatility possible is achieved with a correlation of -1 (assuming positive weights in each asset). Therefore, if you found two assets with equal volatility and perfect negative correlation (-1), you could achieve a theoretical portfolio of 0% volatility when you have equal weights in each asset.
So how do I hedge or diversify on a greater scale?
Many people tend to diversify by investing in multiple industries within the country. While useful, academic research indicates that diversification across countries offers better reward than just industries. The basic idea is that when diversified industry investments are within one nation, if that nation faces sluggish growth or decline, many or all industries suffer the same. Conversely, market declines in one country don’t necessarily imply decline in other countries (as multiple trading partners exist, and often times one nation’s loss is another’s gain). Even in the instance of the 2008 Crisis, while the entire world was impacted, certain countries were impacted worse than others, so at least you are spreading your risk across the board by investing globally.
How can I invest in other countries?
When investing in other countries you are limited to what is executable. You may have a strong conviction that the Indonesian real estate market is ready to takeoff, Qatari bonds are completely overvalued, or the Egyptian Pound is cheap. However, implementing these trades often requires special relationships or significant amounts of capital. If you can not execute directly, look for something that is correlated to your position and utilize this as a proxy investment, such as an ETF.
With our new President-Elect Trump, you may believe the Russian economy is set to grow as relationships between Moscow and DC thaw. In order to take advantage of this, you could consider being long Russian Ruble, Bonds, or Equities. Upon reviewing the ETFs available, you’re likely to find these three equity focused choices suitable: RSX, RSXJ, and ERUS. RSX and ERUS are heavily energy exposed (39% and 49%, respectively), while the Russian small-cap ETF, RSXJ, is only 5%. However, ERUS aims at capturing 85% of the Russian stock market, while RSX and RSXJ focus on capturing not only Russian-domiciled firms, but also firms with 50% exposure to Russia via revenues or assets. If you have a portfolio already long energy, you may decide on a combination of country and industry diversification via RSXJ, the Russia Small-Cap ETF.
What's the hedge?
A potential hedge would be to offset your long RSXJ position by being short a basket of Emerging Market equities. We could implement this trade with the EUM ETF (Short MSCI Emerging Markets). The basic premise here, is that you believe Russia will outperform other large emerging markets (either rise more or fall less thanks to improved US relations). Caveat Emptor! EUM ETF is market cap weighted, and, as a result, Russia is only 3.66% of the portfolio (compared to 27% China, 15% Korea, and 12% Taiwan). If Russian equities outperform (increasing their market cap relative to peers) then the strength of this hedge should improve. Going back to August 2015, RSXJ and EUM have a -0.69 Correlation with an R-Squared of 0.47. While the ETFs have volatilities of 27% and 23% separately, thanks to their negative correlation, a portfolio equally-weighted between the two has a volatility of only 10%. Were you to have put $100 into each in August 2015, your portfolio would have increased from $200 to a current value of $260, 30% gain (+$80 in RSXJ, -$20 in EUM).
As always, you want to make sure that your beliefs match your trade. The use of RSXJ says you believe that small cap Russian stocks will outperform large-cap (primarily Energy), and that Russia will outperform the larger Emerging Markets. If you don’t believe this, but still want to have both trades on, you could adjust the weights (instead of equal dollar exposure) in each investment to better fit your world-view. Be cautious, be prepared, and be involved.
*This is not an endorsement nor recommendation for a trade. Rather, a fun example.
*Edited to improve clarity on description of factors impacting portfolio volatility.
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