Tempted to Reduce Your Hedges? Don't!

by Wayne Ferbert, Minyanville contributor

At my firm, we are always hedged, though the last 12 months have not been a great time to be hedged. Bull markets don’t create profits for hedges. The hedges expire worthless. Your underlying grows, but the hedges drag down the returns.

[Editor's note: The most popular stocks among hedge funds in the past quarter, according to SEC data, are in the tech sector, specifically Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), and Microsoft (NASDAQ:MSFT). Financials Citigroup (NYSE:C) and Bank of America (NYSE:BAC) round out the top five. The order is unchanged since the first quarter of the year, according to SEC 13F filings.]

So, you can imagine, it has been a 12-month window of lagging the market because of the cost of the hedges. The temptation has been to reduce the hedges, or take steps to make them cost less. Maybe reduce protection levels? That's the temptation after a 12-month bull run.

But don’t do it. When the market sends you those signals, that is the wrong time to panic and reduce your protections. Just make sure your hedges really meet your risk tolerance and move on. Changing your hedges to offer less protection now would be the wrong time.

Consider the recent market swoon. There isn't universal agreement on why this market has trended down so strongly since the election. Some blame is placed on the European economy, some on Israeli tensions, and some on the fiscal cliff. Many even just think the market has run too far in too short a time frame. Some think the pending tax changes are causing selling pressure. Too many different reasons should make you nervous that the market will have a difficult time shaking off the doldrums.

All of this is just reason to hold tight on your hedges and not reduce your protections. One thing to consider: If you have options that are downside hedges that are set to expire in December, there's a good chance that they are way out of the money – at least if they were bought on US sectors/markets around six to nine months ago.

Consider salvaging some of the value from them early. Sell them now and roll in to the June or September 2013 protections. We have been doing that for several clients and for our own positions. The modest spike in volatility along with the market decline in the last month has revived the value of these deep-out-of-the-money protections. Salvage that premium while it is still there.

One other unconventional way to play defense: roll some of your US stock market gains in to out-of-favor sectors or markets. If the world markets do swoon together, you should outperform by being invested in the sectors that don’t have as far to fall. And why don’t they have as far to fall? Because they weren’t high-fliers to begin with!

Areas to consider that will likely outperform if a global market swoon occurs: financials, emerging markets, China, and possibly energy. These groups have multiples on their earnings well below their historic highs. That should provide some cushion.

I am not recommending a wholesale re-balance to these investment categories. But rolling around 5% of your portfolio out of the US winners and into these categories should prove useful!