What variety of hedges are there against index funds of U.S. based stocks?

Question

I am a 25 year old investor and I want to build long-term wealth. Right now, I am trying to be tax efficient and am using a buy and hold approach. (My 401k contributions are maxed out each year and this isn't about them.)

To that end, I hold mostly ETFs based on index funds: the Russell 2000, S&P 500, and some specific segment ETFs, e.g. VHT (healthcare), SCHH (REIT), VIS - Industrials ETF, plus technology stocks I purchase individually with a buy and hold approach.

I realized I should try and hedge at least 15% of my portfolio in the event the United States has another economic crisis.

• What are good hedges to complement such a portfolio?
  Here are some I can think of:

  • Gold & silver (what other commodities should I consider?)
  • Corporate bonds
  • Treasury bonds, or a total bond ETF (I'm not sure how corporate bonds would do if the market had a pullback vs. say government or foreign bonds)
  • Foreign ETFs (are Brazil, Russia China, Europe or certain segments more likely to prosper when we have a pullback?)
  • Inverse ETFs (I really wouldn't want to hold these long term – doesn't seem wise, especially with their fees)

• Which ones are better or worse at being oppositely correlated to my holdings?

Surely I am missing some hedge options that I haven't considered?

Answer 1

The only way to hedge a position is to take on a countervailing position with a higher multiplier as any counter position such as a 1:1 inverse ETF will merely cancel out the ETF it is meant to hedge yielding a negative return roughly in the amount of fees & slippage.

For true risk-aversion, continually selling the shortest term available covered calls is the only free lunch. A suboptimal version, the CBOE BuyWrite Index, has outperformed its underlying with lower volatility.

The second best way is to continually hedge positions with long puts, but this can become very tax-complicated since the hedged positions need to be rebalanced continually and expensive depending on option liquidity.

The ideal, assuming no taxes and infinite liquidity, is to sell covered calls when implied volatility is high and buy puts when implied volatility is low.

Answer 2

Even though "when the U.S. sneezes Canada catches a cold", I would suggest considering a look at Canadian government bonds as both a currency hedge, and for the safety of principal — of course, in terms of CAD, not USD.

We like to boast that Canada fared relatively better (PDF) during the economic crisis than many other advanced economies, and our government debt is often rated higher than U.S. government debt.

That being said, as a Canadian, I am biased. For what it's worth, here's the more general strategy:

1. Locate large, politically stable, advanced economies who aren't too deep in public debt.
   (Relatively speaking.)
2. Determine whether the currency might be favorable to own, or not, during a worldwide crisis. e.g. would you want to hold Euros, with the risks that come with that monetary union? Central banks in other economies may have more flexibility to defend their currency and shore up banks.
3. Check whether the government debt is rated highly by the outside.
4. Diversify across the short-term government debt for a selected number of these.

Recognize that you will be accepting some currency risk (in addition to the sovereign risks) in such an approach.

Consistent with your ETF approach, there do exist a class of "international treasury bond" ETFs, holding short-term foreign government bonds, but their holdings won't necessarily match the criteria I laid out – although they'll have wider diversification than if you invested in specific countries separately.