Hedge As An Alternative To Indexing

Excerpted from Build Wealth With Common Stocks, Publishing January 19, 2021 on Country View imprint. Copyright 2020-2021 by David J. Waldron. All rights reserved. Excerpt reprinted with permission of the author.

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Hedge As An Alternative To Indexing

Editor’s Note: The following excerpt is from the upcoming book, Build Wealth With Common Stocks: Market-Beating Strategies for the Individual Investor by David J. Waldron and is reprinted with the permission of the author.

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What is the best alternative to do-it-yourself, active investing? The financial media suggests investing in passive indexes to guarantee your portfolio at least keeps pace with the market.

What is the worst choice? Joining the crowd and trading the short-sighted gimmicks churned out by the Wall Street fee machine is inferior to passive indexing and buy-and-hold common stock investing.

It is typical for the proponents of passive investing in omitting a reminder that indexes contain every company in the market, sector, or industry, translating to owning a lot of poor-quality enterprises in addition to the few good ones. Thus, the superior investor limits the holding of an index exchange-traded fund (ETF) to hedging the common stocks in a portfolio with designs to outperform the market benchmark over time.

The material in this chapter explores the general concept of portfolio hedging—albeit on the long side—and why it is essential to any active, long-term investment strategy.

Using Passive Index ETFs To Hedge A Portfolio

Index ETFs provide the retail investor passively managed funds of publicly traded equities or fixed-income securities. Although safer, in theory, than individual stocks, passive index ETFs carry the shared risks of any equity investing, including the loss of invested capital because of fund company failures, irrational market sentiment, negative financial news, or surprise events.

Passive indexing assures average returns to the market, for better or worse. Index ETFs tend to be less vulnerable to volatility and market liquidity than individual stocks. Thus, the best investing purpose for index ETFs is as a portfolio hedge against a basket of related or conflicting individual stocks as far as market, industry, or capitalization.

When used for hedging, passive index ETFs offer the longer-view retail investor the opportunity for strategic diversification toward a safer portfolio. Diversification presents as a two-edged sword, leaving the over-diversified common stock portfolio best served by passive indexing to lessen risk and lower costs. In contrast, concentrated portfolios of the common stocks of select quality companies—hedged by distribution-paying ETF compounders each purchased at reasonable prices—provide the best opportunity for success for the long-term, retail investor. Suggesting that an active individual investor go 100 percent index funds is akin to recommending that an avid angler buy every fish at the market.

Funds of companies cannot assure that each enterprise represented carries the preceding qualitative parameters. Buying individual common stocks gives the retail investor more control over the quality of the holdings in the portfolio. Nevertheless, even a well-planned and executed long-term value-based portfolio needs to hedge against the inevitable ups and downs of the market. The daily news cycle and quarterly earnings reports drive the speculators to buy, sell, and short recklessly. Be on guard against the unpredictable, although inevitable, external threats to your holdings.

Whether used for active or passive investing, exchange-traded funds, or ETFs, are derivatives notorious for inherent risk from massive investor participation. Warren Buffett has said that makes them candidates for “financial weapons of mass destruction”1 in a down market. Therefore, the defensive hedge positioning of choice is the secondary use of indexed exchange-traded funds.

Look To Vanguard Group For ETF Hedges

Because beating the market with consistency is the Achilles’ heel of the active investor—inclusive of the Wall Street money manager elite—hedge your portfolio on the long side using indexed ETFs tracking the relevant benchmarks. Of note, index ETFs do have lower fees on average than mutual funds. By hedging with an ETF, the thoughtful investor enhances the risk/reward proposition.

On occasion, I have deployed three ETF hedges in our family portfolio: Vanguard Short-Term Inflation-Protected Securities ETF (NYSE: VTIP), Vanguard FTSE All-World ex-US ETF (NYSE: VEU), and Vanguard S&P 500 ETF (NYSE: VOO).

Hedging with the short-duration bonds of US Treasury inflation-protected securities, such as Vanguard’s VTIP, with the stocks of non-US companies, such as Vanguard’s VEU, and with the S&P 500 as represented in Vanguard’s VOO, allows the retail investor to keep pace with the voting machine turbulence of the market in the short-run. Then, focus with confidence on the capital gains and dividend payouts of the weighing machine over time. Each is an excellent choice to hedge against periods when those distinct markets outperform your basket of select common stocks.

I chose Vanguard for ETF hedges because, as a mutual-owned enterprise, it is immune to answering to independent stockholders or outside owners. The objective of Vanguard is to manage each fund at cost, allowing investors to keep more of the returns. The benefits of Vanguard align with the three primary investment objectives of Build Wealth with Common Stocks.

  • Limited capital: Vanguard’s publicly traded ETFs have no criteria for investment minimums beyond the price of one share.
  • Lower costs: At the time of writing this chapter, VTIP carried an annual expense ratio of just 0.05 percent; VEU was a respectable 0.08 percent; VOO was the lowest at 0.03 percent. By using a commission-free online discount broker, you pay pennies for the occasional ETF trade.
  • Less risk: VTIP as a short-duration government bond fund carried a low-risk rating; the international exposure of VEU was earning an average risk rating; VOO as a domestic stock market benchmark also had an average risk rating.

The mutual ownership approach to the investment products of Vanguard satisfies the crux of the mantra of this book in building and maintaining wealth with limited capital, lower costs, and less risk. The three ETF hedges were each paying distributions—the cumulative quarterly dividends or bond yields, plus occasional capital gains from the holdings in the ETF—and offered low portfolio turnover.

Invest in the common shares of quality companies hedged with passive index ETFs through low-cost, online discount brokers, and mutual investment companies such as Vanguard.

Protect Your Portfolio Against Inflationary Cycles

Although deflated interest rates were a boon for equities in the 2009 to 2020 bull market, the ongoing threat to the stock market is inflation—the annualized spike in the price of goods, services, and interest rates. The contrarian thinks of hyperinflation as the third worse menace to the market after high fees from the financial services industry and illogical investor sentiment from the crowd.

Inflation-protected securities, such as VTIP, offer protection against hyperinflation as a potential stock market killer, producing a bounty for the value investor. The objective of short-duration bonds is to provide lower real interest rate risk over several market cycles until acute inflationary pressure rears its head. Nonetheless, we have limited control over trader and investor behavior beyond taking an opposing stance to the irrational investing or divesting by the herd. On the contrary, it is possible to protect our portfolios from unexpected inflation spikes.

Because of historic low-interest rates and deflation, TIPs—Treasury inflation-protected securities—had been a non-story in the great bull market. Forever contrarian, the value investor knows the best time to buy inflation hedges, regardless of the vehicle of choice, is when inflation is off Wall Street’s radar. Traditional inflation hedges had become less expensive as the fast money gobbled up high-yield dividend and non-dividend growth stocks, as well as cryptocurrency.

This chapter is perhaps a simple exercise in value investing because when inflation strikes again, investors will load up on inflation-protected products en masse, whether short-duration bonds, precious metals, or real estate, at much higher entry prices.

What about diversifying a retail portfolio with fixed income, such as bonds or bond funds?

Throughout the second decade of this century, the mainstream financial media was reporting that intermediate and long-duration fixed-income debt instruments—government or corporate-issued bonds, bills, or notes—were a bubble waiting to burst. The extended bull market in bonds dated back to the 1980s, ground zero for borrowing our way to prosperity in America. This self-defeating economic insanity continued forty years later.

Whether in business or at home, consider the accumulation of debt your most significant threat. Strategic debt is beneficial for building foundations in our professional or personal lives, whereas indebtedness to finance an immediate sense of prosperity is often a death knell.

As such, in The Model Portfolio, I favor equity ownership to lending by investing in stocks as opposed to bonds. I also accept that using short-duration Treasury bills as a hedge plays a crucial role in helping to protect the portfolio against the perils of hyperinflation when it occurs.

Double-Down The Hedge

The Model Portfolio represents a concentrated mix of common stocks purchased or available on the two major US exchanges: the Nasdaq Stock Market (NASDAQ) and the New York Stock Exchange (NYSE). Covering the broader market, I benchmark the portfolio against the S&P 500, the citadel of publicly traded American enterprises.

When deployed, the passive Vanguard S&P 500 ETF (VOO) represents the benchmark hedge of The Model Portfolio. At unpredictable times when the portfolio underperforms the S&P 500, VOO picks up the slack.

Although representing companies serving the globe, The Model Portfolio holdings, for the most part, are domiciled in the United States. Therefore, I prefer hedging the basket with the FTSE All-World ex-US Index. The index captures the performance of major exchange-traded companies domiciled outside of the US, and as an independent investor, I never regret taking a globalist view.

My objective is to own an international index as protection against volatility in domestic stocks as opposed to an investment in and of itself. The preferred ETF allocation for foreign hedging is Vanguard’s VEU.

VOO and VEU are market-cap-weighted, the prevailing, if controversial, weighing mechanism. Market cap or capitalization-weighted indexes assign component value by the total market value of the outstanding shares against the cumulative market cap of the index. Thus, the highest market cap stock in the index has the maximum influence on the net asset value of the security.

There are other weighting mechanisms, such as the price-weighted, equal-weighted, and fundamental-weighted. The Dow Jones Industrial Average uses price weighting, where the higher-priced components receive the maximum weight. Equal-weight treats each constituent the same regardless of price or market cap. Fundamental weight employs metrics such as sales, book value, dividends, cash flow, and earnings. Active ETF investors seeking faster growth often turn to the alternative weighting methods in an attempt to hedge any increase in risk.

In a market-weighted index, mega-cap companies dominate a significant portion of the index. For example, in the S&P 500, it is normal for the top ten components to represent over 20 percent of the basket. On the contrary, in the FTSE All-World ex-US such as VEU, the ten largest holdings represented fewer than 10 percent of net assets.

Instead of owning as an outright investment, the objective of the foreign index is protection against the volatility of the concentrated portfolio of domestic stocks. Again, if you want to be an above-average investor, limit any exposure to the S&P 500 or FTSE All-World ex-US indices to hedging. Index hedges are investments by proxy complete with inherent risks, including loss of principal. On the other side of the risk/reward equation, you take profits from the distributions of the index ETFs as well. Nevertheless, each is foremost a hedge on the long side.

The disciplined value investor is less concerned with NAV—net asset value—or premium discounts on ETFs exploited by arbitrage traders seeking a short-term mispricing edge than a more suitable long-term inflation protection or market hedge.

Assets under management in index ETFs have ballooned in recent years. The phenomenon concerns market pundits who believe sizable derivative-driven ETFs such as passive index funds—and perhaps more the speculative leveraged ETFs—will implode or outright trigger a catastrophic financial event in a market correction. Index ETFs are safer as opposed to safe.

Personal Values Drive Politics - Dollar Values Drive Portfolios

Along with owning US companies, whether operating as a domestic or as a multinational, sound portfolio strategy includes hedging with foreign-based companies. The stock holdings of international companies such as represented by the Vanguard VEU ETF are a wise global hedge against US-domiciled publicly traded companies.

The recent populist sentiment toward protectionism and nationalism provides a feel-good platform to generate votes on Election Day with heated debate in the comments of online news feeds and social media. Nationalism and protectionism in the near term aside, globalization and its multinational product and service demand indeed prevail in the long run.

My father shared this thought with me just months before he passed away: “You cannot stop progress, although many forever attempt to bring us back to the ‘way things used to be.’ From a historical perspective, if regressive thinking was successful in halting progress, we’d still be living in caves.”

Whether or not one empathizes with my father’s transformative experience of the world he was about to depart, carrying a conviction of nationalist sentiment to our portfolios sabotages investment opportunities in the global markets. Or, at the least, hedging strategies to protect against our inherent bias toward the stocks of US-based companies. Warren Buffet has promoted a strong bull market case for S&P 500 components over the long-term, and I advocate international exposure at least as a protection against potential US bear markets in the near term.

Politics sometimes validates our values, including emotional attachments to the domestic bliss of American exceptionalism. Our portfolios are best served by rational thinking and an acceptance of globalization as a sound diversification strategy.

Indexing Is For Passive Investors

From an apparent noble concern for the Main Street investor and despite active participation in the markets, Wall Street gurus often advocate passive investing—via mutual or exchange-traded funds—as the best overall strategy for retail investors.

Indexing is appropriate for passive investors with less interest in self-directed investing, or limited trust in the alternative of a fee-and-bonus-focused money manager. For the retail-level investor, passive indexing guarantees your portfolio performance averages to the market, at best. In the spirit of Build Wealth with Common Stocks, using index ETFs to hedge an active portfolio strategy, as opposed to an outright investment, is perhaps the best route in the quest for total return from capital gains and dividends.

Laser your focus on major exchange-traded, common stocks. Avoid the speculative risk associated with illiquid micro caps, defined as lower than $1 billion in market capitalization. In the FOMO-influenced post-Great Recession bull market, micro caps represented over 70 percent of publicly traded companies on the exchanges, both major and over-the-counter (OTC). OTC is defined as traded via a broker/dealer network instead of a centralized exchange.

Investing in OTC issues—predominated by foreign-based enterprises—is speculative at best. Passing on the unnecessary risk forces the investor to miss out on an international staple or two; however, the OTC listing represents the underlying security more than the actual business operation. Perhaps a savvy individual investor is best served by opening a brokerage account that allows the purchase of primary common stock on the major exchange of the country where the company is domiciled. Such an approach adds the challenges of currency exchange rates.

Owning US exchange-traded common shares representing companies paying dividends far outweighs the risks of perceived fast money opportunities from the micro caps and OTCs. Consider keeping your major exchange-traded, non-dividend-paying growth stock allocation to a minimum. Quality dividend stocks compensate you now with regular payouts and reward you later with compounding capital gains. Nonetheless, discipline is an absolute must in choosing to dismiss trend following and momentum stocks, as no one enjoys watching the prices of familiar, yet unowned tickers go up with abandon as happened in the epic bull market. The solace lies in the stomach-turning volatility of the upticks and downslides.

Many unknowing investors lose principal when these speculative stocks, unsupported by sound fundamentals or attractive valuations, take sudden steep price drops. Not unlike the enthusiastic casino gambler, retail investors who chase fast money brag when winning. Yet, unlike the veiled poor gaming results, the vulnerable securities tickers dance across televisions, desktops, and mobile screens.

Increase the chances of tooting your horn more often by owning slices of quality companies paying sensible dividends that keep you compensated in the short-term as you wait for capital appreciation of the underlying stock over the long-term. Hedge those capital gains and dividends with quality passive index ETFs, such as VTIP, VEU, and VOO from Vanguard when the prices are right.

Buy The Best Stocks In The Sector

Don’t buy the sector; buy the best stocks in the sector. Allocate your investment cash to the mispriced stocks of quality companies instead of an equity index or intermediate or long-duration bond fund other than for hedging.

Use equity ETFs as hedges against single company holdings for the expected ups and downs of a market cycle. Avoid using equity index ETFs to hedge against a stock market crash or a prolonged downturn, as each will race to the bottom along with the market. Others promote commodities, precious metals, cryptocurrency, bonds, and more complicated instruments designed to hedge inflation. FDIC-insured cash remains an ideal hedge against market capitulation as cash is the safest alternative other than avoiding equities in general, thus guaranteeing we become below-average, or worse, investors. Therefore, focus on bottom-up equity analysis, finding value in mispriced single ticker stocks that you deem the best in the sector.

To Index Or Not To Index

Warren Buffett’s blanket suggestion of passive indexing for Main Street, notwithstanding, a perpetual head-scratcher is the overall recurrent criticism of Buffett in the financial media. The censure is analogous to finding fault in Albert Einstein, Mark Twain, Martin Luther King Jr., Mother Theresa, or Nelson Mandela. Yes, as in any human, the flaws are there; however, the condemnation appears more as unsubstantiated fear, hate, anger, or envy than a sincere attempt at intellectual critique.

The suggestion for universal indexing on Main Street emanates from others than just Buffett; it often comes from professional investors who share exploits in the financial media. Each buys or shorts stocks, funds, fixed income, options, futures, and derivatives and writes about such ventures following a winning trade, and then tells the reader to buy an index. It is as if the professional has a special Wall Street VIP card of some kind.

And this is where Buffett and his wisdom come back to center court. If these pundits, to whom he offers the more eloquent constructive criticism, beat the market with consistency, the perceived contempt of the investing elite appears as sincere good advice. Since most underperform, it confirms their feeble attempt at covert prose instead of overt results.

To be fair, if a retail investor finds comfort in the safety of average returns, limiting portfolio holdings to the ever-prevalent passive index funds remains a wise choice. Instead of attempting to time the market, consider hedging your portfolio against the likelihood of an irrational herd mentality or less predictable events such as hyperinflation and economic downturns. These words of wisdom from Howard Marks speak volumes: “Following the beliefs of the herd will give you average performance in the long run and can get you killed at the extremes.”2

First, buy the high-quality, reasonably-priced stocks in your sectors of choice; second, hedge the portfolio with passive index ETFs.


Notes

  1. Warren E. Buffett, Berkshire Hathaway, Inc., 2002 Letter to Shareholders, February 21, 2003, 15.*
  2. Howard Marks, The Most Important Thing (New York: Columbia University Press, 2011), 97, original quote published in Marks’s memo to clients of Oaktree Capital Management, L.P.: “The Limits to Negativism,” October 15, 2008.

*Material is copyrighted and used with permission of the author.

Book excerpt is copyright 2020-2021 by David J. Waldron. All rights reserved.

Written for individual investors by an individual investor, in Build Wealth with Common Stocks, David J. Waldron shares actionable ideas to construct a potentially market-beating portfolio of the common shares of enduring companies to fund life’s significant milestones.

Waldron offers inspiring wisdom and memorable anecdotes to keep the reader moving forward during the endless roller coaster rides of market cycles.

“An informed individual investor has a far greater chance of getting rich slow than getting rich fast, and getting rich slowly is better than not at all.”

Build Wealth With Common Stocks

Hardcover is now available for pre-order at major online bookstores in advance of the book’s January 19, 2021, worldwide release.


David J. Waldron

https://davidjwaldron.com/build-wealth-with-common-stocks.html

David J. WaldronDavid J. Waldron is an investor and the author of self-improvement books for those seeking to achieve the personal and professional goals that matter most in their life. He earned a Bachelor of Science in business studies as a Garden State Scholar at Stockton University and completed The Practice of Management Program at Brown University. David and his wife, Suzan, reside in historic South Central Pennsylvania, USA. Full disclosure: The author has no affiliation with The Vanguard Group other than a long position in VEU at the time of this writing.