7/2/2013

Today I want to teach you how a billion dollar hedge fund, like the one I worked for, trades. Hedge funds are called “hedge” funds because they are structured to hedge against downside risks.

That means hedge funds are generally obsessed with risk and controlling risk — contrary to popular opinion. One of the ways to manage or minimize risk is to trade “market neutral.”

For market neutral strategies, funds will generally have a $1 short on their books, for every $1 in long positions. In this case, you’re betting on your stock picking ability, while stripping out the risk of the overall market.

So what can you do today if you want to trade a low volatility market neutral strategy? Use ETFs. ETFs are great. They are extremely liquid, easy to short and they represent an entire market, country, sector or asset class.

So if I were back at a billion dollar hedge fund, I would implement a market neutral trade today by buying $100 million dollars worth of US stocks while at the same time shorting $100 million dollars worth of emerging market stocks. As a retail investor you can execute this same trade through ETFs. In fact, since you don’t have to worry answer to investors about monthly volatility, you can get some extra juice by using leveraged ETFs.

So here is my aggressive billionaire’s market neutral ETF trade : I would be long the ProShares UltraPro S&P 500 ETF (Symbol UPRO). This ETF is leveraged 3X, or 300%. And I would be buy an equal dollar amount of the Direxion Daily Emerging Markets Bear 3X Shares ETF, symbol (EDZ). So, here you are betting that US stocks will continue to go up and that emerging market stocks will drop (or at least not go up as fast). I think this is a great trade from fundamental, monetary policy, and technical perspectives.

Now, if you want to get even more aggressive, I would put on an ETF market neutral options bet. This is a great strategy that even investors with a small account can use. Due to the recent unprecedented move in long term interest rates, I am very bullish on financial stocks (Financial stocks become more profitable as the yield curve steepens, as it is doing now). But because of this, I am very bearish on homebuilders (as higher mortgage rates will hurt future new home purchases). The chart on XLF, the financial sector ETF, looks very strong. Meanwhile the chart on XHB, the Homebuilders ETF, looks like it is starting to break down. The charts are confirming the fundamentals — the move in rates.

Will Meade
President of The Billionaires Portfolio
www.billionairesportfolio.com
wmeade@purealpharesearch.com