Part 2

Can I Hedge Like a Hedge Fund Does?

Hedge funds have come to gain a cultural meaning. They’ve become associated with complex jargon and strategies, and many people may think of them as out of reach. However, many of the tools they use are now available to individuals.

The word has developed a meaning of its own. Still, at the end of the day, much of what they do in terms of managing and hedging risk and taking advantage of leverage is based a lot more on common-sense thinking than you might imagine based on the intimidating language and concepts that can often permeate discussions about these entities.

After the Global Financial Crisis, the image of the industry suffered. Occupy Wall Street and other political currents seemed to gather against Wall Street, and a once-in-generation regulatory overhaul was passed in response. If you pay attention only to the superficial narrative, you may have missed another reality; many tools such as leverage and derivatives that were once only the purview of institutions have been dramatically democratized.

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The retail investor is empowered and has a broader suite of tools to define and manage risk than they have at any other time in history. Behind the evil bank, the narrative is a rapidly shifting landscape that tends to favor the empowerment of the retail investor. We believe this is being augmented by demographic currents and a general change from focusing on wealth preservation to wealth generation.

To understand what a lot of risk management and hedging is all about, let’s dive a little deeper into that metaphor. Black swans are rare; you don’t usually see them compared to white swans. Sort of like we hadn’t seen a major global pandemic since the end of the First World War.

Or sort of like we had never imagined the level of financial contagion that could permeate the economy after the widespread adoption of asset-backed securities. One helpful distinction in the world of hedging is direct hedges versus cross-asset or correlation-based hedges. The chart below illustrates generally useful scenarios for the use of both categories of instruments.

Can I Hedge Like a Hedge Fund Does?

Unfortunately, there is a lot of superficial and misinformed discussion about risk mitigation in finance, given the complexity and mathematics involved. Many new retail investors are using derivatives to amplify their risk and potential returns; however, the powerful financial instruments of derivatives have become the most effective, while also fraught with peril, ways to effectively hedge and mitigate risks. Using leverage enables people to hedge with fewer funds and to protect themselves against volatility.

Even the safest of investments can surprise even the most seasoned analysts. The debt ceiling debate is a perfect example. Is the full faith and credit of the United States Government actually in jeopardy right now?

No, it’s not, but risks we couldn’t have necessarily envisioned years ago now create a tremendous amount of risk, and there is greater than a minuscule chance that some people who purchased what they thought was the safest asset in the world are in for a rude awakening. This is why mitigating, understanding, and, if possible, hedging your risk enables you to invest with more confidence and success.