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Using Absolute Return Funds to Hedge Against a Falling Stock Market

By: , dated June 17th, 2013

Buy low, sell high…right? Not necessarily. When many people think of investing in stocks, they think of purchasing a stock at one price and later selling it for a higher price to make money. Others may consider the dividends paid by some companies as a great way to make a return on an investment when buying stocks. With markets growing increasingly volatile and unpredictable as software trading systems, computer generated trades, and more institutional traders enter the markets, the old adages of “buy low, sell high” and “buy and hold” simply may not be as effective as they once were when the major market participants were individuals, pension funds, and other traditional investors.

The Changing Market Environment

The average annualized volatility of the S&P 500 has nearly tripled since the early 1980s, leading to major short term sell-offs and rebounds over the years. This changing market environment has caused concern and unease for many investors, but others have stepped up to the plate to develop investing strategies and portfolios for addressing the new markets.

Some hedge funds were pioneers in the development of investment strategies to generate absolute returns, and later many mutual funds joined them in managing investment portfolios to hedge against a falling market. Now, there are countless hedge funds and mutual funds that employ these strategies as a core component of client portfolios. Short selling is the basis of these strategies.

Short Selling

What many investors overlook is the strategy of selling a stock short to make money when the market drops instead of buying stocks and hoping it goes up. When an investor sells a stock short, he borrows the stock from another investor who already owns it.  After selling the borrowed stock with the thought that it will go down in price, the goal is to buy it back at a lower price and return the same number of shares back to the original owner. If a stock is selling at $100 per share, and I borrow 100 shares from another investor to sell at the current price, then I bring in $10,000 on the sale. However, I still have to give the original owner his 100 shares back eventually. In the meantime, if the stock drops to $80 per share, I can purchase the 100 shares back for $8,000. I can then return the 100 shares to the original owner, and I’ve made $2,000. This is strategy is how some investors are able to make money when the market is falling and is also the basis for the creation of absolute return funds.

Absolute return managers usually create a portfolio made up of both traditional stock investments as well as short stock positions. If done properly, these positions move in opposite directions at different rates, allowing the managers to make money in both rising markets and falling markets. The short positions make money when the market goes down and lose money when the markets go up. The long positions make money when the market goes up and lose money when the markets go down. In order for this strategy to be successful, the manager must be correct with assumptions regarding the timing of the increases and drops in the market.

Incorporating Short Selling Into a Portfolio

While an absolute return strategy can be a great way to reduce risks in a portfolio and often protect against a falling market, it is important that investors incorporate this strategy as a portion of a larger portfolio and not just make this strategy the core investment. These absolute return and short selling strategies typically provide the greatest benefit when used as a small portion of an investors overall investment portfolio to protect the portfolio against major unforeseen drops in the overall market.

This article was brought to you by the InvestorGuide Staff Writers and Editors.

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