There is no disagreement that moving toward a high percentage of cash in a down market will be good, and even better than a short hedge in an up market. I think the definition of what was initially suggested as a hedging tool quite a few comments up got lost.

Again, not a long-term strategy, but it is no different than when you buy put options when you are long a stock.

In your example, moving 40% to cash instead of 20% to short results in a loss of $300 on QQQ and a gain of $32 on your cash . . . so you lose $268, a better outcome than your short/long scenario. It will always be better to do this, no matter where the market goes, because the two scenarios are identical except the cash earns interest and the long/short tradeoff doesn’t. Try it with a market that moves up . . . same situation.

The long/short on the same equities is not smart as a hedge in any situation. You are always better moving the funds that you offset to cash.

I’m just saying that even though it isn’t ideal to hedge with the same asset, it could be better than moving the same percentage of your portfolio to cash.

For example, take a $10,000 portfolio in QQQ. Let’s say over the course of 2 months it increases in value 5%. You realize a $500 gain. Just like if the market saw a 5% loss, you’d lose $500.

But if you weren’t sure where the market was headed, but wanted to reduce a little risk, so you wanted to move 20% of your assets into something else.

In the first case, you moved 20% into the Short QQQ. Let’s say again, the next two months the nasdaq is down 5%. This time, you realize a loss of $300. Then let’s assume in the other example you moved that 20% into cash earning 5% APY instead, so over 2 months it earns 0.82%. In this portfolio you would have realized a loss of $383.60, or lost over $80 more.

All things being equal, you fair better in a short-term decline with the short position vs. cash. Of course, the more money you move away from the long position and into either the short holding or cash the better you fair. And in an up market it is a losing strategy altogether, it only serves as downside protection.

Like you said, this is NOT a long-term strategy, and you’re right, you never want to mitigate long-term risk with an asset that is expected to decline in the long term against something you expect to increase in value.

The best way to diversify for the long run is with stocks and bonds, two asset classes that over time have proven to always increase, just at different rates with different volatility.

– 50% of your money goes up 5% (long position)
– 50% of your money goes nowhere (the other 25% in long and the 25% in short cancel each other)

That other 50% would be better served in a MM fund/account no matter where the market goes. At least it’s getting that 0.41%, whereas your offsetting ETFs are guaranteed to get 0 or worse (due to ETF expenses).

I’m not saying half cash is a good allocation at all. I’m saying owning an ETF and the ETF that shorts is is a very bad allocation, and is beaten by replacing the offsetting funds with a fixed account. It’s never a good idea to hold an asset and its inverse, as you’ll only be spinning your wheels.

The bottom line with hedging is you don’t want to hedge with something that will effectively NEGATE your gains in other investments. You want to mitigate risk, but both positions better have long-term expected growth. Inverse ETFs have long-term expected losses. That’s not a good asset to hold except in the short term if you feel the market is declining (but I don’t play that game).

Of course, if we could predict the future, certainly protecting your losses with cash will almost always win out, but if you keep shuffling your portfolio around and moving 50% or more into cash you could hurt yourself just as much if your predictions are wrong and things take back off again. So, by hedging a little bit with a short position (doesn’t have to be 75/25, that was just an example) you can remove some of the volatility without relying on timing the market by fussing with your asset allocation.

And like brad said, I’m not sure I’d use them as a direct hedge against other holdings. As he mentioned, if you owned QQQ and hedged it with some Short QQQ, as long as the correlation remained nearly 1:1 you’d just cancel out. Although you could own say 75% QQQ and 25% PSQ, which would ultimately reduce volatility. You wouldn’t see the highest gains in an up market and wouldn’t see the biggest losses in a down market.

I think the best use of these types of funds is when you want to capitalize during the relative short-term when you see potential markets declining. For instance, if I was heavy in large cap stocks and it looks like small cap might be headed for trouble, rather than adjust my overall portfolio I could just pick up some small cap short etf.

Brad – Thanks for that chart, that is a great illustration of the correlation.

Steve – I’m with you, I don’t know very much about these types of alternative investments either, which is one of the reasons I bring it up here so that by discussing them, hopefully everyone can learn something. If I ever get my CFA, maybe I’ll understand how these products work.