Today is such a beautiful day in West Vancouver that I'm actually sitting outside while I write! Unfortunately I have a lot of work to do so I'll make this shorter than normal.

From Around The Blogoshpere

Michael James On Money finds that the average market average is not very average!

Zahid Jafry is concerned that Certified Financial Planners are writing FEWER financial plans than before.

While many personal finance bloggers abhor active management, Financial Jungle discusses some managers that have "skin in the game" and beat the market too. 

And finally, Mike from The Quest For Four Pillars asks why some parents are morons. 

This Week's Racing Video

In the spirit of brevity, this video is a Formula One pit stop during which all four tires are replaced and a simulated full tank of fuel added in mere seconds (this was just a practice stop, but they kept the car in place and simulated the time required to fill it up). I would actually enjoy filling up at the gas station if it was like this!

I received an email a few days ago from a reader who asked about hedging a portfolio, specifically using HXD which is the Horizons BetaPro S&P/TSX 60 Bear Plus Fund. What a mouthful! For those who are not familiar with double and double inverse ETFs, essentially they provide 200% of the daily performance of an underlying index which in this case is the S&P/TSX 60 index. (Click here to read a more in-depth description I wrote a while back)

The regular Bull ETF will return 2% when the S&P/TSX60 is up 1%, and will return -2% when the index is down 1%.

The Bear version gives you 200% of the inverse performance so if the S&P/TSX is up 1%, the Bear ETF IS DOWN 2%. If the index is down 1%, the Bear ETF is UP 2%.

Here is the original email:

I enjoy your blog and wonder if you would consider a column on the ins and outs of using a hedge (notional or formal) to reduce investment risk. A concrete example might be based on a primary investment in the TSX index with a hedge using the Horizon S&P TSX Bear Plus ETF(HXD). Or bonds. Or ishares XIN. Or ...? When is it a hedge and when is it diversification? How much is enough? etc.

Hedging is the complete opposite of Speculation. Another way to put it is that speculation is the taking on of risk in the hopes of a higher reward, and hedging is the elimination of risk and the elimination of higher potential rewards. The two are diametrically opposed.

Let's assume that our test investor invests in XIU - which is the iShares ETF that tracks the S&P/TSX60 index. In order to completely hedge the portfolio (reduce all risk), he would need to hold 1/3 of his portfolio in HXD (the double inverse ETF that tracks the same underlying index). While he was doing this, his portfolio will be a flat line (actually it will be a slightly negative line over time as the MERs of each ETF will create a small drag on the portfolio). If he only wanted to reduce a portion of the volatility he could use smaller amounts of HXD. The graph below shows the the effects of different levels of hedging.

You can see that holding 33% HXD completely removes risk from the portfolio and completely removes all returns as well. This is a perfect hedge. By using smaller percentages of HXD you can reduce the level of volatility (and corresponding returns) as much as you want.

So when would you hedge? Clearly from above, it would make sense that long term investors would not need to hedge their portfolios. If the goal is to reduce volatility ONLY, then as a long term investor you would look for other investments that had similar return expectations and low or negative correlation to your existing assets. That is diversification and it is different from hedging specifically because you are only trying to reduce volatility, not returns (hedging does both).

I've added a new feature to this blog today: Skribit. If you look on the right hand side you will see a new widget that says "What should I write about?". If you ever want to make a suggestion for a topic that you would like to read more about, just click on the widget and enter in your suggestion. For example, you could click and then write something short like:

TFSA
Option Strategies
Market Action
RRSPs
Budgeting
etc.

You can also vote for topics that are listed - so if someone suggested 'option strategies' and then 50 other people voted for it, you can be sure to see more blog posts about option strategies on this blog since my goal is to more fully engage all the readers and deliver content that you want to see.

NOTE: You can make your suggestions and votes anonymously, but I believe you can set up an optional profile with Skribit as well. (I'm still figuring it out). If you sign up for a Skribit profile you can choose to be notified when I write a post based on your suggestion. If you are a regular reader though, I wouldn't bother since you'll see it posted anyways and as I'm new to Skribit, I can't recommend the service yet.

So, I'll try out this new feature for a while and see how it goes. As always, if anyone has suggestions or wants to otherwise get in touch with me, you can always send me a private message as well.