Decide Whether Hedging or Shorting Are for You - dummies

By David Stevenson

Hedge-fund and absolute-return managers frequently get bad press from many UK investment commentators. The common charges centre on concerns about poor performance and high costs, plus a smattering of more systematic concerns, such as questions regarding the opportunistic nature of new managers in the market, the relative lack of regulatory oversight (at least until recently), and even whether the strategy itself works, given the overall poor performance of funds.

But hedge-fund managers should be applauded for the noble objective (not always achieved) of trying to preserve your capital in any market. That aim forces them to be creative, which means that they’re willing to consider strategies that include hedging their portfolio, shorting expensive assets and thinking unconventionally.

Hedging is a simple concept to comprehend. Imagine opening a very large position on the FTSE 100 benchmark UK equity index. You believe it will rise in the next year but you’re also slightly worried that the local economy may suddenly slow down, hitting local share prices.

Hedging involves working out the value of your main position and then opening up a counter-balancing position where you make a profit if your investing idea goes in the opposite direction: that is, the FTSE 100 goes down.

You may for instance look to invest in another asset that can be relied upon to increase in value while the FTSE 100 is falling in value (called negative correlation in finance jargon). Government bonds, for example, can usually be relied upon to do the exact opposite of local equity markets, and so may be a perfect hedge.

Shorting — where you make money from a financial asset falling in price — can be an essential part of a hedging strategy. In simple terms, you open a position with a broker where you sell an asset (that you probably don’t own at that moment in time) and then wait for it to fall in price.

Imagine selling shares in ACME PLC for £100. You may be selling these shares in a naked fashion, which fortunately doesn’t mean that you’re sitting in the nude on the telephone but that you don’t own shares in ACME PLC.

Your plan is that in two months’ time the price of ACME will be only £80 per share at which point you’d buy the shares (for £80) and then sell them, as agreed with your broker, for £100 each. Hey presto, a profit of £20 even though you don’t own the asset!

Although shorting is widely used, it’s the subject of much debate and controversy. Many central banks hate the idea of ‘shorting’ shares in vitally important institutions such as banks. They worry that short selling may bring down a bank, causing economic carnage.

Also, shorting is risky: get it wrong and you can end up losing a vast amount of money very quickly, especially if the price of the underlying asset keeps going the wrong way.

You can also use alternative shorting strategies in hedging that involve using options. These essentially involve the same outcome but make use of derivatives-based options that increase in value as the index (or share) they’re tracking goes down in price. These puts, as they’re called, are widely used in financial markets and can be a brilliant way of hedging a portfolio.