Simple “Hedge Fund” Investment Techniques for the Average Person
With the World’s economy starting to “turn-around” and now Iran’s threat to disrupt the shipping routes of oil tankers passing through the Middle East. Many analysts are expecting the price of oil to once again climb to new record levels over the next few months. If you’re one of the many expecting oil prices to rise, it may be a perfect time to implement some of my “hedge” techniques to protect yourself from rising gas and home heating oil prices!
There has been a lot of animosity towards hedge fund managers and the excessive amounts of money these individuals make. It is understandable considering some of the most “talented” hedge fund managers have annual total compensation packages in the 100’s of millions of dollars.
Adding further to the frustration is the fact that most hedge funds (although similar to standard mutual funds) are not openly available to the average person and are instead only available to “sophisticated investors” who must have minimum networths and investment knowledge before being “certified” to invest in these various funds.
Hedge funds are aggressively managed and have the potential for much larger swings in value (compared to the general markets). Although the term “hedge” actually implies that money is invested in certain financial investments to protect or reduce the risk in other investments, however, hedge fund investors are under no illusion that their investments are low risk.
While the majority of these hedge fund investments are “wicked” complicated (as we like to say here in Maine), there are a variety of relatively simple strategies the average everyday investor can utilize to improve their financial situation.
To illustrate how the average investor can use simple hedge strategies to protect their investment with a low risk traditional hedge technique, let’s look at one of my favorite financial topics: the ever changing price of a gallon of gasoline.
Suppose that the price of gasoline has come down recently and you are fearful that the price of gas will go back up in the next few months. What if there was a way to lock in or “hedge” the price of gasoline that you pay over the next year? Actually, there is a very simple way that you can do just that and it doesn’t involve building a gigantic gasoline storage tank in your back yard!
Here’s how to hedge against to threat of rising gasoline prices:
Let’s say you were happy with the current gasoline price of $3.00 per gallon but feared the price might rise over the next year (for whatever reason).
Estimate the amount of gasoline you expect your household to use over the next year, for our example let’s say this was 1,000 gallons.
Multiply that 1,000 gallons by the current price of gas to get your “hedge” amount, for our example this will be $3,000 or $3.00 per gallon times 1,000 gallons.
Then, purchase $3,000 of the United States Gasoline Fund ETF (ticker symbol: UGA) through a discount brokerage firm. Although this may sound super risky and complicated, purchasing shares of Electronically Traded Funds (ETFs)like the “UGA” is just as easy as buying shares of individual stocks. You can buy them through any online discount broker such as TD Ameritrade, Charles Schwab, or Scott Trade. Just don’t get carried away with day trading like I did during the Internet bubble.
OK, so that seems relatively easy enough, but you’re probably still asking yourself how this technique actually locks in the price of gasoline for you for 1,000 gallons of gasoline over the next year. Fortunately, I’ve created the following Excel chart to show you how this works:
In scenario 1, we assume that we follow my plan above and by the end of the year the average price you have paid for the year’s gasoline is $4.35. The total cost of gasoline over this time would be $4,350 (Ouch), but, your investment in the ETF Gasoline fund would also rise by roughly* the same percentage as the price of gasoline you paid (compared to your $3.00 per gallon target price). Therefore you would have gained $1,350 in your investment value bringing your total net cost for gasoline to $3,000 (or $3.00 per gallon).
In scenario 2, the average price of gasoline remains constant throughout the year and therefore averages the target price of $3.00. Your investment in the gasoline ETF also remains unchanged so there is no profit or loss.
In Scenario 3, the average price of gasoline in the following year drops to $2.25. Although you only pay $2,250 for the same 1,000 of gasoline, you lose $750 in your gasoline ETF investment thus bringing you back to your original target price per gallon of gas at $3.00 per gallon.
While investing in the United States Gasoline Fund ETF is not a perfect hedge against fluctuating gasoline prices (gasoline prices can vary quite a bit by region), it should provide reasonable protection in helping you reach your target price per gallon of gas of $3.00 or whatever the current price of gasoline is that you want to “lock in”).
Not only can you use this strategy for protecting yourself against rising gasoline prices, you can use a similar strategy in protecting yourself against rising heating oil prices and other commodities as well.
Some potential drawbacks of this strategy.
The first drawback of this strategy is the cost of executing the ETF trade through a discount brokerage account. However, most online discount brokerages will allow you to make this trade (both the buy and the sell) for under $10.
The second drawback of this strategy is the loss in the “time value of money”. Simply stated, you are losing out on investing the $3,000 in some other financial product such as a savings account, certificate of deposit, or mutual fund.
* The UGA is not a 100% accurate hedge against the price of gasoline. There will always be some fluctuations in the volatility of gas price vs. the volatility of the UGA price although the comparisons should be reasonable for the intent of this example.
Too Much Debt? Download our free Trees Full of Money Debt Snowball Calculator and see how quickly you can pay off your debt.