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.
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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:
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?
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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.