For 2009, Insulate Your Portfolio

With the demise of hedge funds, the word "hedge" has taken on a whole new meaning that's not all that pleasant. But most hedge funds blew up not because they made wrong bets but because they levered up recklessly. They failed to learn anything from the experience of Long Term Capital Management: Excessive leverage can render the most brilliant and correct trades worthless. The smartest guy in the room can be made to look dumb by using leverage.

While expectations are that the back half of 2009 will look brighter for equities, this market has taught us not to bank on expectations. No one is going to disagree that things can get a bit worse before getting better. Unfortunately, many portfolios are already decimated, but a degree of protection or additional liquidity is always welcome. As we enter a new year, consider the following hedging methods.

The market is down by almost 50% from its peak in October of 2007. Unless you believe that the Dow will hit 4500 next year, hedging against the market will not prove as valuable in 2009 as it did in 2008. In fact, longtime bear Prem Watsa at Fairfax Financial (FFH - commentary - Cramer's Take) recently eliminated the equity hedges on Fairfax's portfolio. Having said that, one easy and effective way of hedging your portfolio is to short the indices and let your long positions ride.

The most obvious hedge entails shorting the S&P Depository Receipts (SPY - commentary - Cramer's Take). Nothing fancy here. The ProShares Ultrashort S&P 500 (SDS - commentary - Cramer's Take) and Ultrashort Dow (DXD - commentary - Cramer's Take) are designed to produce investment results that correspond to twice the inverse of the daily performance of the S&P 500 and Dow Jones Industrial Average.

The advantage (or disadvantage) of ultrashorts is you get a levered return without using leverage in your portfolio. In other words, if you wanted to hedge 15% of your portfolio against a general market decline, you could go short 15% of your portfolio's assets in SPY. On the other hand, you could go long 7% SDS or DXD and get the same hedge.

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At the time of publication, Gad had no positions in stocks mentioned, although positions may change at any time.

Sham Gad is the managing partner of the Gad Partners Fund and the Gad Partners Offshore fund, value-centric investment partnerships based in Athens, Georgia. Gad has written extensively for the Motley Fool and was a securities analyst for UAS Asset Management, a small, value-focused fund in New York City in 2007. Previously, Gad managed assets for the Gad Investment Group. For additional information, please visit www.gadcapital.com.

Gad also runs a value-investing blog inspired by the teachings of Benjamin Graham and Warren Buffett. Additionally, he is currently working on a value investing book to be published by John Wiley & Sons in the fall of 2009. Gad earned his BBA and MBA at the University of Georgia. Send Sham Gad an email. You can reach Gad at [e-mail].