Hedging For The Short-Term And The Long-Term

Whether or not an investor utilizes hedging techniques can have a large impact on both their short-term and long-term performance. Hedging involves trade-offs. You are minimizing losses, but also likely capping gains. Our portfolio, however, features a differne tkind of hedge, and it is one that we would like readers to be aware of. The AdvisorShares Active Bear ETF (HDGE) has a unique approach to hedging, one that differs from traditional short ETF's. The most well-known short ETF is the ProShares Short S&P 500 (SH). This fund gives investors short exposure by shorting every stock in the S&P 500. The ETF is a good short-term hedge against market volatility.

Problems begin, however, when the ETF is held for long periods of time. The ProShares ETF resets itself daily, which, over time, means that it loses its ability to act as a hedge. The fund's performance over the past year serves as proof of this. Over the past year, the S&P 500 has lost a bit less than 1%. Common wisdom would suggest that the ProShares Short S&P 500 ETF would be up around that much. Yet the fund is down over 7%, due to the the fact that it resets daily. How is an ETF that shorts the market down more than the market? It is because that ETF is meant as a short-term hedge and a trading vehicle, not a long-term holding.

The AdvisorShares Active Bear ETF, however, takes a different approach to shorting. It is an actively managed fund, and rather than shorting the entire market, it shorts select stocks that its portfolio managers think have poor earnings quality, accounting issues, or other financial weaknesses that will make their shares fall. This approach works in both the short-term and the long-term. In the short-term, this ETF acts like a general market hedge, because the companies it shorts are the ones that are the most likely to fall (and fall the hardest) in a weak market. Currently, 2 of the funds top holdings are Citigroup (C) and Deutsche Bank (DB). And whenever the market is in a panic, over either the situation in Europe or some other macroeconomic pressure point, these 2 companies are almost always sell off more than the market. The Active Bear ETF's emphasis on financially weak companies helps drive outperformance in the short-term.

It is why over the past year, the fund is up over 8%, far more than one would expect from a short ETF, based on the performance of the S&P 500. As for the long-term, we are confident that this fund will prove to be a useful long-term hedge. At the moment, however, the fund has not yet proven itself in the long-term, because it launched in February 2011, which has not given it enough time to build a long-term track record. That being said, the fund's emphasis on financially weak companies will drive long-term outperformance. Among the companies the fund has shorted (or still shorts) are Green Mountain (GMCR) and OpenTable (OPEN), 2 companies that have experienced dramatic collapses in their share price. We are confident that the managers of this ETF can continue to successfully find new companies that are poised for meaningful drops in their share prices.