Chapter Eight: Hedging as an Alternative to Indexing
Revised and updated | Build Wealth with Common Stocks: Market-Beating Strategies for the Individual Investor
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Chapter Eight
Hedging as an Alternative to Indexing
What is the best alternative to do-it-yourself, active investing? The financial media recommends investing in passive indexes to ensure your portfolio at least keeps pace with the market.
What is the worst choice? Joining the crowd and trading based on shortsighted gimmicks churned out by the Wall Street fee machine is worse than passive indexing and buy-and-hold investing in common stocks.
Proponents of passive investing often overlook the fact that indexes encompass every company in a market, sector, or industry, which translates to owning a mix of both poor-quality and exemplary companies. Therefore, a smart investor limits holding an index exchange-traded fund (ETF) to hedge against the common stocks in a portfolio, aiming to outperform the market benchmark over time.
This chapter discusses the general idea of portfolio hedging—specifically on the long side—and explains why it is crucial to any active, long-term investment plan.
Using Passive Index ETFs to Hedge a Portfolio
Index ETFs offer retail investors passively managed funds comprising publicly traded equities or fixed-income securities.
Although safer, in theory, than individual stocks, passive index ETFs carry the shared risks of any equity investment, including the loss of invested capital due to fund company failures, irrational market sentiment, negative financial news, or unexpected events.
Passive indexing assures average returns to the market, for better or worse. Index ETFs tend to be less vulnerable to volatility and market liquidity than individual stocks. Thus, the best investing purpose for index ETFs is as a portfolio hedge against a basket of related or conflicting individual stocks, particularly in terms of market, industry, or capitalization.
When used for hedging, passive index ETFs offer the longer-view retail investor the opportunity for strategic diversification toward a safer portfolio. Diversification presents as a two-edged sword, leaving the over-diversified common stock portfolio best served by passive indexing to lessen risk and lower costs.
In contrast, concentrated portfolios of select high-quality companies, hedged by distribution-paying ETFs, offer the best opportunity for long-term success for retail investors.
Suggesting that an active individual investor go 100 percent into index funds is akin to recommending that an avid angler buy every fish at the market.
Funds of companies cannot assure that each enterprise represented carries the preceding qualitative parameters. Buying individual common stocks gives retail investors more control over the quality of the holdings in their portfolio.
Nevertheless, even a well-planned and executed long-term value-based portfolio needs to hedge against inevitable market fluctuations. The daily news cycle and quarterly earnings reports drive the speculators to buy, sell, and short recklessly. Be vigilant against the unpredictable, yet inevitable, external threats to your holdings.
Whether used for active or passive investing, exchange-traded funds are derivatives notorious for their inherent risk due to the massive participation of investors. Warren Buffett has said that they make them candidates for “financial weapons of mass destruction” in a down market.1
Therefore, the defensive hedge positioning of choice is the secondary use of indexed ETFs.
Consider Vanguard Group for ETF Hedges
Because beating the market with consistency is the Achilles’ heel of the active investor—inclusive of the Wall Street money manager elite—hedge your portfolio on the long side using indexed ETFs tracking the relevant benchmarks.
Notably, index ETFs generally have lower fees on average than mutual funds. By hedging with an ETF, the thoughtful investor enhances the risk/reward proposition.
On occasion, I have deployed three ETF hedges in our family portfolio: the Vanguard Short-Term Inflation-Protected Securities Index ETF (NASDAQ: VTIP), the Vanguard FTSE All-World ex-US ETF (NYSE Arca: VEU), and the Vanguard S&P 500 ETF (NYSE Arca: VOO).
Hedging with the short-duration bonds of US Treasury inflation-protected securities, such as Vanguard’s VTIP, with the stocks of non-US companies, such as Vanguard’s VEU, and with the S&P 500 as represented in Vanguard’s VOO, allows the retail investor to keep pace with the voting machine turbulence of the market in the short run.
Focus with confidence on the capital gains and dividend payouts of the weighing machine over time. Each is an excellent choice to hedge against periods when those distinct markets outperform your basket of select common stocks.
I chose Vanguard for ETF hedges because, as a mutual-owned enterprise, it is not beholden to independent stockholders or outside owners. The objective of Vanguard is to manage each fund at cost, allowing investors to retain a greater portion of the returns. The benefits of Vanguard align with the three primary investment objectives of Build Wealth with Common Stocks.
Limited capital: Vanguard’s publicly traded ETFs have no criteria for investment minimums beyond the price of one share.
Lower costs: At the time of updating this chapter, VTIP carried an annual expense ratio of 0.03 percent, VEU was 0.04 percent, and VOO was at 0.03 percent. By using a commission-free online discount broker, you pay pennies for the occasional ETF trade.
Less risk: VTIP, as a short-duration government bond fund, carried a below-average risk rating. The international exposure of VEU also earned a below-average risk rating, and VOO, as a domestic stock market benchmark, had an average risk rating.
The mutual ownership approach to Vanguard’s investment products aligns with the crux of this book’s mantra: building and maintaining wealth with limited capital, lower costs, and less risk. The three ETF hedges were each paying distributions—the cumulative quarterly dividends or bond yields, plus occasional capital gains from the ETF holdings—and offered low portfolio turnover.
Consider complementing the common shares of high-quality companies by hedging with passive index ETFs through low-cost, online discount brokers and mutual fund companies, such as Vanguard.
Shield Your Portfolio from Inflation Cycles
Although deflated interest rates were a boon for equities during the 2009-2020 bull market, the ongoing threat to the stock market is inflation — the annualized increase in the price of goods, services, and interest rates.
The contrarian views hyperinflation as the third worst menace to the market, after high fees from the financial services industry and illogical investor sentiment from the crowd.
Inflation-protected securities, such as VTIP, offer protection against hyperinflation—a potential threat to the stock market—and can yield a return for value investors. The objective of short-duration bonds is to provide lower real interest rate risk over several market cycles until acute inflationary pressure rears its head. Nonetheless, we have limited control over trader and investor behavior beyond taking an opposing stance to irrational investing or herd behavior. On the contrary, it is possible to protect our portfolios from unexpected inflation spikes.
Because of historic low-interest rates and deflation, TIPs—Treasury inflation-protected securities—had been a non-story in the great bull market. Forever contrarian, the value investor knows the best time to buy inflation hedges, regardless of the vehicle of choice, is when inflation is off Wall Street’s radar. Traditional inflation hedges had become less expensive as the fast money gobbled up high-yield dividend and non-dividend growth stocks, as well as cryptocurrencies.
This chapter may be a simple exercise in value investing, as when inflation strikes again, investors are likely to load up on inflation-protected products en masse, whether in the form of short-duration bonds, precious metals, or real estate, at much higher entry prices.
What about diversifying a retail portfolio with fixed income, such as bonds or longer-duration bond funds?
Throughout the second decade of this century, the mainstream financial media reported that intermediate- and long-duration fixed-income debt instruments—government- or corporate-issued bonds, bills, or notes—were a bubble waiting to burst. The extended bull market in bonds dates back to the 1980s, when borrowing became a common practice, often referred to as “leveraging our way to prosperity.” This self-defeating economic insanity continued forty years later.
Whether in business or at home, consider debt accumulation your most significant threat. Strategic debt is beneficial for building foundations in our professional or personal lives, whereas indebtedness to finance an immediate sense of prosperity is often a harbinger of financial doom.
As such, in The Model Portfolio, I favor equity ownership over lending by investing in stocks rather than bonds. I also acknowledge that using short-duration Treasury bills as a hedge plays a crucial role in protecting the portfolio against the perils of hyperinflation when it occurs.
Double Down on the Hedge
The Model Portfolio represents a concentrated mix of common stocks purchased or available on the two major US exchanges: the Nasdaq Stock Market (NASDAQ) and the New York Stock Exchange (NYSE).
Covering the broader market, I benchmark the portfolio against the S&P 500, the citadel of publicly traded American enterprises.
When deployed, the passive Vanguard S&P 500 ETF (VOO) represents the benchmark hedge of The Model Portfolio. At unpredictable times when the portfolio underperforms the S&P 500, VOO picks up the slack.
Although representing companies serving the globe, The Model Portfolio holdings, for the most part, are domiciled in the United States. Therefore, I prefer hedging the basket with the FTSE All-World ex-US Index. The index tracks the performance of major exchange-traded companies domiciled outside the US, and as an independent investor, I have never regretted adopting a global perspective.
My objective is to own an international index as a hedge against volatility in domestic stocks, rather than as an investment in its own right. The preferred ETF allocation for foreign hedging is Vanguard’s VEU.
VOO and VEU are market-cap-weighted, the prevailing, if controversial, weighing mechanism. Market cap or capitalization-weighted indexes assign component value based on the total market value of the outstanding shares divided by the cumulative market cap of the index. Thus, the highest market cap stock in the index has the maximum influence on the net asset value of the security.
There are other weighting mechanisms, such as price-weighted, equal-weighted, and fundamental-weighted. The Dow Jones Industrial Average uses price weighting, where the higher-priced components receive the maximum weight. Equal-weight treats each constituent equally, regardless of price or market capitalization. Fundamental weight relies on metrics such as sales, book value, dividends, cash flow, and earnings. Active ETF investors seeking faster growth often turn to alternative weighting methods in an attempt to hedge any increase in risk.
In a market-weighted index, mega-cap companies dominate a significant portion of the index. For example, in the S&P 500, it is typical for the top ten components to account for over 33 percent of the index. On the contrary, in the FTSE All-World ex-US, such as VEU, the ten most extensive holdings represented about 10 percent of net assets.
Instead of owning as an outright investment, the objective of the foreign index is to protect against the volatility of a concentrated portfolio of domestic stocks. Again, if you want to be an above-average investor, limit your exposure to the S&P 500 or FTSE All-World ex-US indices for hedging purposes. Index hedges are investments made by proxy, complete with inherent risks, including the potential loss of principal. On the other side of the risk/reward equation, you take profits from the distributions of the index ETFs as well. Nevertheless, each is foremost a hedge on the long side.
The disciplined value investor is less concerned with NAV—net asset value—or premium discounts on ETFs exploited by arbitrage traders seeking a short-term mispricing edge than with a more suitable long-term inflation protection or market hedge.
Assets under management in index ETFs have ballooned in recent years. The phenomenon concerns market pundits who believe that sizable derivative-driven ETFs, such as passive index funds—and perhaps more so the speculative leveraged ETFs—will implode or outright trigger a catastrophic financial event during a market correction. Index ETFs are “safer” rather than ironclad.
Personal Values Influence Politics
Dollar Values Shape Portfolios
Along with owning US companies, whether operating as domestic or multinational entities, a sound portfolio strategy includes hedging with foreign-based companies.
The stock holdings of international companies, such as those represented by the Vanguard VEU ETF, serve as a prudent global hedge against U.S.-domiciled publicly traded companies.
The recent surge in populist sentiment toward protectionism and nationalism provides a feel-good platform to generate votes on Election Day, with heated debate in the comments sections of online news feeds and social media. Nationalism and protectionism aside in the near term, globalization and its demand for multinational products and services indeed prevail in the long run.
My father shared this thought with me just months before he passed away: “You cannot stop progress, although many forever attempt to bring us back to the ‘way things used to be.’ From a historical perspective, if regressive thinking were successful in halting progress, we’d still be living in caves.”
Whether or not one empathizes with my father’s transformative experience of the world he was about to depart, by carrying a conviction of nationalist sentiment, we sabotage investment opportunities in global markets. Or, at the least, hedging strategies to protect against our inherent bias toward the stocks of US-based companies. Warren Buffett has made a strong case for the bull market in S&P 500 components over the long term, and I advocate for international exposure at least as a protection against potential US bear markets in the near term.
Politics sometimes validates our values, including emotional attachments to the domestic bliss of American exceptionalism. Our portfolios deserve rational thinking and an acceptance of globalization as a sound diversification strategy.
Indexing Provides Benefits for Passive Investors
From an apparent noble concern for the Main Street investor, despite active participation in the markets, Wall Street gurus often advocate for passive investing—via mutual or exchange-traded funds—as the best overall strategy for retail investors.
Indexing is suitable for passive investors who are less interested in self-directed investing or have limited trust in a fee- and bonus-focused money manager. For the retail-level investor, passive indexing guarantees that your portfolio performance averages the market, at best. In the spirit of Build Wealth with Common Stocks, using index ETFs to hedge an active portfolio strategy, as opposed to an outright investment, is arguably the most profitable route in the quest for total return from capital gains and dividends.
Focus your laser-like attention on major exchange-traded, common stocks. Avoid the speculative risk associated with illiquid microcaps, defined as having a market capitalization of less than $1 billion. In the FOMO-influenced post-Great Recession bull market, microcaps represented over 70 percent of publicly traded companies on both major and over-the-counter (OTC) exchanges. OTC is defined as traded via a broker/dealer network instead of a centralized exchange.
Investing in OTC issues—predominated by foreign-based enterprises—is speculative at best. Passing on the unnecessary risk forces the investor to miss out on an international staple or two; however, the OTC listing represents the underlying security more than the actual business operation. Perhaps a savvy individual investor is best served by opening a brokerage account that allows the purchase of primary common stock on the major exchange of the country where the company is domiciled. Such an approach adds the challenge of currency exchange rates.
Owning US exchange-traded common shares representing companies that pay dividends far outweighs the risks of perceived fast money opportunities from microcaps and OTCs. Consider keeping your major exchange-traded, non-dividend-paying growth stock allocation to a minimum. Quality dividend stocks compensate you now with regular payouts and reward you later with compounding capital gains.
Nonetheless, discipline is an absolute must when choosing to dismiss trend-following and momentum stocks, as no one enjoys watching the prices of familiar yet unowned tickers rise with abandon, as happened during the epic bull market. The solace lies in the volatility of the gratifying upticks and stomach-turning downslides.
Many unknowing investors lose their principal when these speculative stocks, unsupported by sound fundamentals or attractive valuations, experience sudden, steep price drops. Not unlike the enthusiastic casino gambler, retail investors who chase quick profits often boast when they win. Yet, unlike the veiled poor gaming results, the vulnerable securities’ tickers dance across the screens of televisions, desktops, and mobile devices.
Increase the chances of tooting your horn more often by owning slices of quality companies paying sensible dividends that keep you compensated in the short-term as you wait for capital appreciation of the underlying stock over the long term. Hedge those capital gains and dividends with quality passive index ETFs, such as VTIP, VEU, and VOO from Vanguard, when the share prices exhibit attractive valuations.
Buy the Best Stocks in the Sector
Don’t buy the sector; buy the best stocks in the sector. Allocate your investment cash to the mispriced stocks of high-quality companies, rather than an equity index or an intermediate- or long-duration bond fund, except for hedging purposes.
Use equity ETFs as hedges against single-company holdings to mitigate the expected fluctuations of a market cycle. Avoid using equity index ETFs to hedge against a stock market crash or a prolonged downturn, as they will likely decline in value along with the market.
Others promote commodities, precious metals, cryptocurrencies, bonds, and more complex instruments designed to hedge against inflation. FDIC-insured cash remains an ideal hedge against market capitulation, as it is the safest alternative to avoiding equities in general, thus guaranteeing that we become below-average investors.
Therefore, focus on bottom-up equity analysis, identifying value in mispriced single-ticker stocks that you deem the best in their respective sectors.
To Index or Not to Index
Warren Buffett’s blanket suggestion of passive indexing for Main Street, notwithstanding, a perpetual head-scratcher is the overall recurrent criticism of Buffett in the financial media.
The censure is analogous to finding fault in Albert Einstein, Mark Twain, Martin Luther King Jr., Mother Theresa, or Nelson Mandela. Yes, as in any human, the flaws are there; however, the condemnation appears more as unsubstantiated fear, hate, anger, or envy than a sincere attempt at intellectual critique.
The suggestion for universal indexing on Main Street originates from sources beyond Buffett; it often comes from professional investors who share their insights in the financial media. Each buys or shorts stocks, funds, fixed income, options, futures, and derivatives, and writes about such ventures following a winning trade, but then tells the reader to buy an index. It is as if the professional has a special Wall Street VIP card of some kind.
And this is where Buffett and his infinite wisdom come back to center court. If these pundits, to whom he offers more eloquent and constructive criticism, consistently beat the market, the perceived contempt of the investing elite appears as sincere good advice. Since most underperform, it confirms their feeble attempt at covert prose instead of overt results.
If a retail investor finds comfort in the safety of average returns, limiting portfolio holdings to the ever-prevalent passive index funds remains a wise choice. Instead of attempting to time the market, consider hedging your portfolio against the likelihood of an irrational herd mentality or less predictable events such as hyperinflation and economic downturns.
These words of wisdom from Howard Marks speak volumes: “Following the beliefs of the herd will give you average performance in the long run and can get you killed at the extremes.”2
First, buy high-quality, reasonably priced stocks in your chosen sectors. Second, hedge the portfolio with low-cost, low-risk passive index ETFs.
CHAPTER EIGHT SUMMARY
On Hedging Instead of Passive Indexing with ETFs
Passive index investing assures average returns to the market, whereas hedging a portfolio of common stocks with low-cost exchange-traded funds provides increased diversification and safety.
If hedging your portfolio, the index ETFs from Vanguard Group are wise choices because, as a mutual-owned enterprise, it is immune to independent stockholders or outside owners.
FDIC-insured cash is the safest hedge against market capitulation.
Investing in the common shares of quality international companies outside the US is indeed a noble endeavor, as, despite nationalism and protectionism dominating the news cycle, globalization, driven by multinational demand for products and services, prevails in the long run.
The thoughtful investor buys slices of the best companies in the sector, reserving the entire universe for hedging.
This updated chapter is copyrighted 2021 and 2025 by David J. Waldron. All rights are reserved worldwide.
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Warren E. Buffett, Berkshire Hathaway, Inc., 2002 Letter to Shareholders, February 21, 2003, 15. Material is copyrighted and used with the permission of the author.
Howard Marks, The Most Important Thing (New York: Columbia University Press, 2011), 97, original quote published in Marks’s memo to clients of Oaktree Capital Management, L.P.: “The Limits to Negativism,” October 15, 2008.