Hedging is the idea of taking an investment position which is intended to offset potential losses. In June last year, I bought some shares of Fairfax Financial Holdings Ltd. (TSX:FFH) as a hedge.
At the time, the company had hedged its equity and equity-related holdings against a potential broad and systemic decline in equity markets.
The company has also hedged against a deflationary scenario by buying derivatives, which were linked to consumer-price indexes in the United States, the European Union, the United Kingdom, and France.
In a February press release, the company revealed that it had removed its equity index hedges due to “fundamental changes in the U.S. in the fourth quarter that may bolster economic growth and business development in the future.”
The thing is, it costs to hedge. In 2016, Fairfax realized losses of US$2.6 billion due to its equity hedges and short equity exposures, resulting in net losses on investments of US$1.2 billion.
Thankfully, the company’s insurance operations were doing fine and generated US$1 billion of operating income. Still, the company posted a net earnings loss of US$512.5 million for the year due largely to its investment losses.
What are some other ways to hedge?
Some investors who have an equity-heavy portfolio may get nervous as the stock market is near its all-time high. Other than doing the extreme and shorting the market, which can get costly and complicated, they can instead consider holding more cash.
Sure, it’s costly to hold cash, as it hardly produces any returns from interest. However, it is useful for cushioning the impact of a down market. The lower stock prices get, the more valuable cash become, as it can be used to scoop up cheap shares.
Some investors also opt to buy gold bullion as a hedge. The precious metals miners have generally underperformed the market in the last few years. Some investors might consider buying Barrick Gold Corp. (TSX:ABX)(NYSE:ABX) or Silver Wheaton Corp. (TSX:SLW)(NYSE:SLW) as a hedge. Investors can also hedge with a fund, such as Market Vectors Gold Miners ETF (NYSEARCA:GDX) if they don’t want to pick individual miners.
As we saw with Fairfax, it can be very costly to hedge. More often than not, hedging can weigh on your portfolio.
Like any investment, investors should think about the opportunity cost of hedging and if hedges are necessary for their own portfolios.
If Fairfax is right and the U.S. economy gets bolstered, the company should generate better results going forward.
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Fool contributor Kay Ng owns shares of FAIRFAX FINANCIAL HOLDINGS LTD. The Motley Fool owns shares of Silver Wheaton. Fairfax Financial and Silver Wheaton are recommendations of Stock Advisor Canada.