Wayne P. Weddington III likes ETFs as a hedging tool. (Photo by Lonnie C. Major)

Why do wealthy investors and institutions pay millions of dollars in admission fees to get into hedge funds? Because hedging—or using investment strategies that reduce financial risk—works. Says Nadia Papagiannis, editor of Morningstar Alternative Investments Observer: “Defensive investing can improve your long-term results.”

So, why doesn’t everyone do it? Well, hedge funds represent “the ‘velvet rope’ of the investment community,” explains institutional investor Wayne P. Weddington III in his book, Do-It-Yourself Hedge Funds (Grand Central Publishing; $24.99). “Yes, you can be invited to the party, but the guest list is predicated on you having a bank balance of more than $5 million,” the SEC requirement for investing in an unregulated fund. Aside from expensive initial investments, hedge funds present other barriers for average investors. Their fees are quite steep; and liquidity is very low, as many funds put limits on your ability to withdraw your own money. Another downside: Because hedge funds are not regulated by the federal government, many of them operate under extreme secrecy. Even investors aren’t privy to all the ways their money is being used.

Fortunately, you no longer have to own your own Caribbean island to participate in hedge fund strategies. Thanks to a handful of newly popular investment products, you can employ hedging techniques in your own portfolio—at a relatively low cost.

According to Morningstar’s Papagiannis, an increasing number of mutual funds offer strategies that hedge fund managers typically follow. “With these mutual funds,” she says, “the minimum investment might be a few thousand dollars and you have daily liquidity. Fees are relatively high for mutual funds, but still much lower than what investors pay for hedge funds.”

Several types of investment vehicles deliver hedging strategies:
Long–short funds: Out of some $33 billion invested in “alternative mutual funds,” long–short funds have almost $28 billion. They use some of their assets to buy favored stocks and other investments; these are “long” positions, in industry lingo, because they’re owned by the funds, which will profit from price appreciation.

These funds also go short: they borrow securities expected to perform poorly and sell them at today’s prices. If those prices drop, the funds will buy back the securities at the lower price, return them to the lender, and thus clear a profit on the deal. In a bear market, when most stocks drop, profitable short positions can keep long–short funds from being clawed too badly.

“Most long–short funds are net long,” says Papagiannis, “because it’s easier and less risky to make money on the long side than on the short side, and because over the very long run the stock market has produced a positive real return.” If a fund is 60% long and 40% short, for example, it is 20% net long. It probably will participate partially in a bull market and not lose as heavily in a bear market.

Market neutral funds: These funds are designed to be neither net long nor net short. They attempt to add value by picking winners, on the long side, and by identifying laggards, on the short side.

Arbitrage funds: Funds in this category try to take advantage of market dislocations. In merger arbitrage, for example, a fund might buy the stock of the target company while shorting the shares of the acquirer. In convertible arbitrage, a fund might buy convertible bonds while shorting the stock of the company issuing the bonds. In these and other situations, the long–short structure provides downside protection while a skilled arbitrageur seeks to profit from mispriced assets.

How have these mutual funds performed? “They helped investors during the 2008 bear market,” says Papagiannis. The broad U.S. stock market (represented by the S&P 500 Index) lost 37% that year while the funds in Morningstar’s long–short category lost 15.4%, on average. That wasn’t a great performance but many investors would have been happy to lose only 15% in 2008.

Hedging against the downside usually means giving up some upside. Through the first 10 months of 2009, the long–short category gained only 7.5%, on average. During that time period, the S&P 500 was up more than 17% and the average domestic stock fund returned nearly 21%. Nevertheless, for the 22-month period (2008 plus 10 months of 2009), an investor would have been better off with the typical long–short fund than with the typical long-only domestic stock fund.

You might wonder, “Why do I need a long–short fund or any kind of alternative mutual fund? Why can’t I do it myself—go long on the stocks I like best, and go short on stocks I like least?” Frankly, short selling is not recommended for lay investors. It is complicated and extremely risky. Because short selling involves borrowing shares whose values can fluctuate wildly, you have unlimited loss potential if the stock you’re shorting shoots up instead of down.

ETFs: One way to avoid these problems is to buy “short exchange-traded funds,” also known as “inverse ETFs.” An ETF is a fund (often a collection of securities) that you can buy and sell on an exchange, just like a stock. In his book, Weddington, a partner at Brunswick Partners in New York, calls ETFs “the most effective instrument available to you to effect hedge strategies in your own portfolio. With ETFs you can truly accomplish what the professionals do.” Virtually all ETFs are index funds: they track a specific index. Inverse ETFs, though, are designed to move in the opposite of the index: If the S&P 500 goes down by 2%, for example, an inverse ETF based on the S&P 500 would go up by 2%. (A leveraged or “ultra” inverse ETF would go up 4%.) Of course, if the S&P 500 rises, the inverse ETF falls.

That may sound like an ideal way to hedge your stock market risk. You don’t need to set up a margin account; you can buy an inverse ETF through any broker, just as you’d buy a stock. There’s no interest to pay to carry the ETF and your loss is limited to the amount you invest.

So what’s the catch? “Inverse ETFs reset daily,” says Tom Lydon, president of Global Trends Investments in Newport Beach, California, and founder of ETFtrends.com. Thus, if the S&P 500 is up 1% on Monday, an inverse ETF on that index will fall by 1%. If the S&P 500 is down 0.4% on Tuesday, the inverse ETF will rise by 0.4%. And so on, day after day. Over time, the ETF’s result may drift from a true inverse.

For example, Vanguard Emerging Markets Stock ETF (VWO) tracks an index of stocks from the developing nations of the world. Those stocks were hit hard in 2008 so this ETF was down by 52%. You would expect an inverse ETF to be up by around 52% for that year but Short MSCI Emerging Markets ProShares (EUM) gained only 20%. Moreover, UltraShort MSCI Emerging Markets ProShares (EEV), which aims to double the inverse of the underlying index, actually lost 25%. “Inverse and leveraged ETFs are not for everyone,” Lydon concludes. “They are good to use in a situation where an investor wants to hedge current positions without having to sell them, or to capitalize on short-term moves in the markets.”

Papagiannis suggests that investors interested in hedging start with a long–short mutual fund, and perhaps some other alternative mutual funds, within their portfolio. “Shorting is not just the opposite of going long,” she says. “It takes very specific skills to successfully go short. Investors should look for funds managed by people who are experienced in short selling; the more concerned you are about stock market risk, the greater the portion of your portfolio you might allocate to alternative mutual funds.”

This article originally appeared in the January 2010 issue of Black Enterprise magazine.

We all know what happened to stocks in 2008. And while shares staged a rally early in 2009, many pundits say the upswing could be short-lived.  The Federal Reserve, meanwhile, has slashed interest rates in the name of buoying the economy, a move that has brought bond yields down to miniscule levels.  And if that isn’t enough, many experts now believe the Obama administration’s efforts to save the economy could bring about a period of high inflation.

At first blush, TIPS seem to hold many answers.  As a bond, they offer stability – the promise to provide investors with steady amounts of income twice a year and return their principle after a specified period of time. What’s more, TIPS are issued by the Treasury Department and backed by the U.S. government, a debtor that despite recent deficit spending still enjoys a good reputation in the investment community. To cap it all off, the initial invested principal holders put into TIPS rises and falls in value to keep pace with inflation as measured by the consumer price index or CPI.

TIPS aren’t the only inflation-fighting bond offered up by the Treasury.  I-bonds, another offering, are pegged to the CPI as well, but offer investors less flexibility.  TIPS are adjusted to CPI fluctuations monthly, whereas I-bonds are tweaked twice a year in May and November.  TIPS can be bought and sold through a broker at any time; I-bonds must be redeemed and cannot be traded.  I-bond holders pay a penalty if they opt out within the first five years.

Investing in TIPS is fairly straightforward.  They come in five-, 10- and 20-year maturities – that is, the number of years investors receive interest payments before their principal is returned.  Investors can purchase TIPS directly from the government in $100 denominations at Treasurydirect.gov. There are a couple of important caveats nonetheless.  One consideration is that TIPS income payments are taxed as income by the government, an assessment that can take a sizable chunk out of the bonds’ return.

As a result, financial advisers say a TIPS investment works best in a tax-deferred IRA or 401(k) account.  Another thing to keep in mind is that during deflationary periods, a TIPS’ underlying value decreases in line with the CPI.  Lawrence Jones, an analyst with the Chicago investment research company Morningstar, says while investors, “don’t have to bet the house,” on TIPS, a 5% to 10% allocation in a personal portfolio makes sense.

Brown and other experts say there are a number of advantages to buying TIPS mutual funds rather than individual bonds.  First, the mutual funds are actively managed by professionals who monitor the bond market and inflation trends and who can select the best times to buy and sell holdings.  Fund managers hold many investments in a diversified portfolio, and by spreading money across a number of positions, they manage to take advantage of the most favorable market conditions and protect your investment from a downturn.  “Diversification and the expertise of a portfolio manager are clear advantages a mutual fund brings to what is a low-volatility investment,”  says Dawn Brown, senior financial adviser for money management firm Altfest Personal Wealth Advisers.

According to Jones, “TIPS’ valuations can vary quite widely, and individual investors can often be skittish and sell out at the wrong time.  It pays to have someone experienced at the helm of a portfolio who can buy and sell at the best time.”

Mutual funds, of course, come at a price, and annual fees are assessed on investor returns.  Also, many of the better offerings require a minimum initial investment of $1000 or more.  Jones recommends shopping for funds with an expense ratio of 0.50% or lower.

HOT TIPS

Recommended Treasury Inflation-Protected Securities mutual funds:

Vanguard Inflation Protected Securities (VIPSX)

One-year yield: 3.79%

Expense ratio: 0.20%

Minimum investment: $3,000

Telephone:  800-662-7447

American Century (ACITX)

One-year yield: 4.37%

Expense ratio: 0.49%

Minimum investment: $2,500

Telephone: 800-345-2021

PIMCO Real Return D (PRRDX)

One-year yield: 2.29% yield

Expense ratio: 0.90%

Minimum investment: $1,000

Telephone: 800-426-0107

Source: Morningstar

Make no mistake; the outlook for the industrial sector isn’t all rosy, observes Holland, who has covered the sector for Morningstar since early 2007. But even as makers of power generators or farm machinery might see factory floors stall in 2009, others in the sector are ramping up production of alternative power sources and renewable energy equipment. And a clever few have found ways to generate income by helping other companies increase efficiency.

That’s a marked break from the past. Traditionally, industrials don’t trend downward until well into an economic slump—and don’t rebound until a recovery is well underway. Their business, after all, requires hefty contractual agreements with utilities, contractors, and other customers who are reluctant to back out of orders when things slow down, and equally hesitant to begin heavy spending at the first sign of an upturn. The upshot: Holland suggests the next 12 months won’t be a banner year for sales and profits. That doesn’t, however, spell doom for all of the companies he follows. In fact, when considering the 2008 stock market retreat, some key industrials are trading at sizable discounts.

Why should investors look at the industrial sector now?
Recently, they’ve been gaining a lot more publicity, particularly as energy efficiency and alternative power sources—wind turbines, solar cells, and solar panels—have been in the limelight.
There’s a lesser theme:  In a tight, low-growth economy, some of the industrials have leveraged their expertise and made a niche for themselves by working with other companies to improve their distribution channels or their overall production efficiency.

When you look at the economy as a whole, it’s safe to say that 2009 is going to be a tough year. Many companies in the group will see revenues go down, but there are glimmers of good news, too. Indications are that there is a lot of money that’s going to go into the nation’s energy production for everything, from nuclear power plants to wind turbines and alternative technologies. In early November, there was news that China is planning to sink another $600 billion into its infrastructure over the next few years, which should help.

In the current environment, what numbers do you look at to gauge a company’s value?
Well, our criteria aren’t markedly different from what we normally use. I keep an eye on return on invested capital, for instance, to see how well a company is using the money it borrows or gets from shareholders in order to boost earnings. Typically, I start to get interested at a 10% return, and I’m very intrigued once we get to 15% and greater. We focus on cash flow. That’s critical at a time when it’s difficult for the best of companies to get financing. It’s also important to determine how much and what type of debt a company has and whether or not management can keep up with principal payments. In most cases, a debt-to-capital ratio of more than 33% means there might be a problem.

Are there any intangible factors that make a company’s shares attractive?
Sure. At Morningstar we like companies with a “moat.” That’s our way of saying that they’re in a business where competition is minimal, and where there are significant barriers potential rivals must cross to vie for market share. In some cases, well-protected companies have spent years developing products and relationships with customers. In other cases, distribution channels are hard to come by and can protect an existing business from encroachers.

A good example is my first pick Watsco (WSO), which currently is the largest heating and air conditioning equipment distributor in the United States. The stock has been beaten down. It’s well below what we think is a fair value of $45 a share. Watsco has developed very significant relationships with big manufacturers and contractors, which should help once the housing construction slowdown comes to an end. In the meantime, a couple of factors bode well for the stock. For one, there’s no way for individual customers to buy air conditioners directly from the factory.

What’s another company you like?
Emerson Electric (EMR) is very interesting. It’s an electric equipment company with very diverse offerings, and has found ways to beat the cyclical nature of some of its markets. One strategy has been to help other companies with process management, helping clients boost efficiency. There’s more: The company has a very strong history of giving money back to shareholders. In the first three quarters of 2008, Emerson earned $2.1 billion—they handed $837 million to shareholders in dividends and then used another $853 million to buy stock back. Even so, the stock trades at a very large discount to a fair value, which we place at $60 a share.

Distribution advantages and process efficiencies are big now. Are there any other names that play on those themes?
My third pick, Thomas & Betts (TNB), an electrical equipment manufacturer, has landed on an interesting variation of that theme. The company makes electrical parts of all sizes, covering the whole spectrum from the high to low end. They make everything from outlet boxes to switches and more. Its product line is broad, something you don’t really see in the commercial or residential market. What’s more, Thomas & Betts has launched an initiative through its distribution networks. The company promises to ship every component a big customer (such as a contractor) buys, in one complete and very efficient order. We place the stock’s fair value at $42 a share, well above its current market price.

This article originally appeared in the January 2009 issue of Black Enterprise magazine.