Hedging your bets: Long/short strategies for a souped-up market
2013 was an incredible year for the stock market. In fact, for the past two years, stocks have been on an unbelievably good run. Which begs the question: What should you do to hedge your bets?
I've seen the stock market rise and fall many times during my career and found it prudent to take some profits off the table during the good times—thus limiting losses during a market correction. In the past, we investors considered diversifying some of the money we had in stocks by investing in other assets that provided decent yields, such as bonds.
But those other options simply aren't attractive now. Bond yields are low, and interest rates may soon rise. So what are we to do in terms of reducing our exposure to stocks while also keeping our money working for us?
One option investors and advisors may consider is exploring additional investments in long/short equity mutual funds.
(Read more: Stocks still tops, advisor survey finds)
The idea is to invest in funds that employ a strategy of owning attractive investments (longs)—where the manager is betting that these stocks will increase in value—while shorting overvalued/unattractive companies (shorts), which are bets that these stocks will lose value. When done skillfully, this is one way investors can maintain exposure to stocks while having reduced exposure to volatility and the market as a whole.
What makes this strategy so appealing now is that not all stocks gained at the same rate in 2013. In fact, according to investment management firm Eaton Vance, lower-rated stocks went up more than those more highly rated by Standard and Poor's (S&P): C-rated stocks were up 57.7 percent through Nov. 30, while A-plus-rated stocks were up a more modest 22.3 percent. The S&P 500 itself was up 29 percent.
This performance discrepancy creates an opportunity for a fund to go long high-quality companies while shorting low-quality stocks.
When it comes to choosing a fund, be aware that long-short managers generally employ one of three philosophies:
- At one end of the spectrum is a fund that employs a market-neutral strategy. The idea here is the fund will pair longs and shorts, dollar for dollar, with the goal of minimizing market risk, while expecting the longs will outperform the shorts. An example might be that of two similar companies in the same sector with wildly different valuations, where one company is priced in the stratosphere and the other's price is in the basement. The fund would essentially bet that the valuation difference between the two companies will narrow, capitalizing on this by going long the undervalued company and going short the overvalued one.
- At the other end of the spectrum, you'll find funds that go "all in" by investing 100 percent in either long or short bets. Typically used by hedge funds, this strategy is all about winning—or losing—big. These funds are akin to market-timing strategies.
- The strategy we employ is considered somewhere "in between," as I like to tell my clients. We look for funds that typically have 30 percent to 70 percent net-long exposure (total longs minus total shorts). The expectation is that exposure to stocks should achieve attractive total returns over the long run while reducing volatility that would come from being "all in." In essence, our goal is to find funds that are going long high-quality companies while shorting companies they think are overvalued and might drop in price. Even in the face of an overall market correction, our portfolio should be protected from significant losses, because we expect the lower-quality stocks to fall at a much faster pace than higher-quality ones.
"Our goal is to find funds that are going long high-quality companies while shorting companies they think are overvalued and might drop in price."
Consider asking the following questions when selecting funds that fit with your investment philosophy:
—What's the manager's historical record with long-short equity investments? Have there been wild swings in performance and exposures?
—What is their investment discipline? How do they go about identifying their long and short bets?
—And based on the prospectus, how much exposure to long-short investments can they have?
(Read more: Recovering economy may rein in bull market)
When it comes to deciding what to do in portfolios, I like to compare it to driving a car that's gaining a bit too much speed for comfort. Sure, you can take your foot completely off the gas and hit the brakes, like cashing out of stocks and going to cash. Our goal with the hedged equity strategy is to just ease up on the gas and maintain a little more control.
—By Barry Glassman, Special to CNBC.com.
Barry Glassman is a certified financial planner and founder and president of Glassman Wealth Services.