Must-know: Simple strategies to hedge against draw-downs in equity
There are very simple ways to protect your investment in equities.
Diversify your investment across companies as well as industries. Also, industries you choose shouldn’t be complementary in nature. There should be a good mix of both cyclical and non-cyclical industries stocks. Cyclical industries are those that are sensitive to the business cycle, such that revenues are generally higher in periods of economic prosperity and expansion and lower in periods of economic downturn and contraction. For example, consider the airline and retail industries. In good economic times, people have more disposable income, so spending in these industries tends to increase, translating into industry growth on a macro level.
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In times of a downturn, consumers tend to curtail their expenditures in cyclical industries. That’s when investments in defensive industry stocks act as a hedge. Defensive industries, like healthcare and utilities, are those whose sales and earnings remain relatively stable during both economic upturns and downturns, since demand for the products or services offered by companies in these industries are relatively inelastic.
The chart above shows more volatility in the iShares US Industrials ETF (IYJ), which tracks cyclical stocks like General Motors (GE) and Boeing Co. (BA). On the other hand, the iShares US Consumer Goods ETF (IYK), which tracks defensive stocks like Procter & Gamble Co. (PG) and Coca-Cola Co. (KO), is relatively less volatile.
You can hedge volatility in cyclical industry ETFs to an extent by investing in defensive industry ETFs.
Inverse equity ETFs
Another way to hedge against draw-downs in equity is to invest in an inverse ETF. Much like with bonds, you’ll have to carefully select a particular inverse ETF that’s designed to reverse the trend of the industry where your stock belongs. The ProShares Short S&P 500 and the ProShares UltraShort S&P 500 fall in this category of ETF.