by Michael McCarthy

Alert readers are aware that the ‘investor strategy call’ is intact. Here’s a recap:

  • The global investment outlook remains difficult. The numbers are mildly positive, but there are significant risks.
  • The global outlook is further clouded by the conflicting actions of central banks. While the US Fed tightens, banks such as the European Central Bank (ECB) and the Bank of Japan (BoJ) continue to man the pumps. These cross flows add to market volatility and uncertainty.
  • The outlook for the Australian economy remains modestly positive, despite a number of local distractions such as the Federal election campaign. Sentiment swings are the likely major driver of market moves in this scenario.
  • The share market performance overall could remain sideways, with the Australia 200 index respecting a range between 4800 and 5400.
  • This means “buy and hold” strategies are unlikely to deliver the best returns. Instead, rewards in the current environment may go to active investors – those willing to take advantage of market swings.

The above fits with the current picture of the market:

The index has respected the range since August last year. Not every rally reaches the top of the range, nor does every sell off fall to the bottom of the range. However, those who have actively sold when the index is around 5300 or higher, or bought when the index is around 4900 or lower, are giving themselves the opportunity to create market-beating returns.

How investors buy or sell is another matter. Of course, the most obvious alternative is to trade individual stocks, trimming a portfolio near the top of the trading range, and adding to it at the bottom. This is a straightforward approach which satisfies the demands of an active strategy. While suitable for many investors, there are alternatives for those concerned about the costs and tax implications of portfolio churn, or want a simpler method.

Active Alternatives

The choices available to investors are broad, and the right choice for an individual depends as much on their circumstances as any market considerations. Possibilities include selling and buying stock, CFDs, ETFs, futures, and taking or writing (buying or selling) put and call options over the index or individual stocks. Today, I’m looking at just one of the possible paths – whether or not it is suitable to any particular situation is a decision entirely for the individual.

Portfolio hedging in a single transaction

One reason investors choose to hedge their portfolio using Australia 200 index CFDs is simplicity. In many cases, the hedge is put in place with a single transaction, and lifted in the same way. Additionally, there is no need to disturb the underlying portfolio and create tax events. Investors can continue to collect dividends while the capital risks of the portfolio are offset by a sold index CFD position.

That is, as the market falls the portfolio will lose value, but a short-index CFD position will increase in value. The reverse is also true. Should the market rise, gains on the portfolio are reduced by losses on the short index CFD.

One of the key questions for investors considering selling an index CFD is whether the index is a good approximation of their portfolio. This is important because it can determine how well the hedge tracks the portfolio. Unless the portfolio exactly comprises the top 200 stocks in their current index weights, there will be tracking error as the market moves. The index is approximately 50% financial stocks, around 20% resources, and the rest, a mix of industrial, healthcare and consumer stocks. If an investor’s portfolio approximates these weightings, an index CFD can be a useful hedge, albeit not exact.

How many?

How does an investor determine the right amount of CFDs to sell? Let’s imagine a hypothetical investor, with a $300,000 portfolio that’s broadly in line with the index. The investor notes the index is near the top of the recent trading range, and wants to sell (something) to honour their active investment strategy.

To determine the number of CFD contracts, divide the portfolio value by the current level. $300,000 divided by 5170 is 58.02. Rounding, the investor would sell 58 Australia 200 index CFDs to hedge 100% of the value of the portfolio.

However, the investor may think there is a risk the market could trade out of the top of the range (this time). An approach that takes this into account could sell half the value – 29 CFDs – and wait for a slide to get under way before selling the remaining 29. Another investor may think a fall is a near certainty, and decide to sell 150% of the portfolio value, or 87 CFDs.

The appropriate transaction is up to the individual, as is the size of the trade. However, current market conditions demand action from investors.