With more than 10,000 hedge funds on market holding $1.5 trillion in assets, if you don’t have any money in a hedge fund you may wondering if you missing out of the big game. The Yale University endowment is 25% invested in hedge funds seeking absolute returns.

But with the emergence of exchange-traded funds or ETFs, you have at your fingertips the ability build a global ETF hedge portfolio that is the envy of your friends - and you won’t have to give away 20% of your gains to a hedge fund manager.

What is a Hedge Fund?

Before we get into how to build your ETF hedge portfolio, let’s look at the history of hedge funds and how they have evolved. Hedging means to reduce risk while speculation is seeking more return by taking on more risk. A hedge fund is a private investment partnership that invests with goal of more return than risk for each dollar invested. The first hedge fund was started by a former Fortune magazine columnist Alfred Winslow Jones in 1949 and he also set the standard for fees which continues to this day: a fee equal to 2% of assets and a performance fee of 20% of gains. There are an infinite variety of hedge funds but they can be broken down into two categories. Non-directional funds seek absolute returns by using a long/short approach and tend to generate steady but unspectacular returns. Directional funds allocate assets using only limited hedging. Both seek alpha – return over a benchmark from the investment process, skill of the fund manager or let’s face it, just plain luck.

Mediocre Hedge Performance

How are hedge funds doing? In 2005, according to CS Tremont index, average global macro fund returned 7.6% versus 10% for MSCI EAFE index - and in 2006, 13.5% compared to 18% for the MSCI World index. According to study by Henry Kat of the London Business School, only 17.7% of hedge funds provided investors with returns they could not have generated themselves. Why? Most attempt to exploit anomalies within markets and asset classes rather than between markets and asset classes. Many hedge funds try to do too much and look at too many markets but still lack global diversification. The result? Hedge funds have become commodities competing for opportunities in the same markets.

ETF Advantages

You can build a diversified global ETF hedge portfolio by tactically allocating ETFs with the goal of exploiting anomalies between global markets rather than in markets. The tools are certainly there with over 400 ETFs now at your fingertips from 20 different country ETFs, U.S. sectors and sub-sectors, international sectors, global sectors, commodities, precious metals, currencies, regional, inverse ETFs, different asset classes and growth/value choices.

Investors now also have a choice regarding how companies are selected and weighted in the ETF baskets. Company weighting in the ETF basket is done on the basis of market value, revenue, fundamentals, technical factors, cash dividend record are just some of the choices.

Besides the variety, there are other reasons to go with ETFs such as tax efficiency, flexibility, transparency, and the increasing availability risk management tools such as inverse ETFs, put options, stop losses and the ability to sell short.

Despite these ETF advantages, you will still need a disciplined process with clear action triggers and risk management tools to lock in gains, minimize the impact of mistakes and a comfort level with periodic high cash levels.

Cash, Liquidity and Income Come First

You also have to think through how this portfolio fits into your overall investment plan. Put in place plenty of liquidity through cash or money market funds. You also need a strong comfort level regarding income to meet your current and long-term needs. A good advisor can run a model for you so that, even in the worst case scenario, you will be safe and secure. With this security plan in place, you can then look confidently and at more creative and higher potential for growth portfolios such as a global ETF hedge portfolio.

Set Global Asset Allocations

But what should be the investment process for selecting and removing ETFs from your global hedge portfolio? Here is how Chartwell approaches it.

Before jumping ahead to select a basket of ETFs, we first use a top down approach by allocating assets among different equity markets such as the U.S., Europe, Asia-Pacific and emerging markets as well as some foreign currencies.

Then we set a target allocation for fixed income and inverse ETFs which move opposite of markets and serve as a hedge or portfolio buffer for down markets. Next, we address real assets by making allocations for precious metals, real estate, timber, oil and other commodities.

The Yale Model

This is close to how large endowments are managed at universities across America. For example, below is the asset allocation for Yale University which was described in a recent New York Times article. Yale’s endowment has grown at an annual compound rate of 16% from $1.3 billion in 1986 to $14 billion in 2006.

Real Assets 7.8%
Hedge Funds 23.3%
Private Equity 16.4%
Foreign Equity 14.6%
Domestic Equity 11.6%
Fixed Income 3.8%
Cash 2.5%

At this stage in the cycle and accepting that most investors will have less access to hedge funds and private equity, my preference would be to allocate more to U.S. and foreign equities and to have a larger cash position than the Yale model.

A Process to Filling Your Allocations

The next step is to fill your allocations with appropriate ETFs. Here is the selection process we use that might serve as a model.

First, you need to look at the fundamentals of the top 5-10 companies in the ETF you are considering. These include the composite price to book, p/e ratio relative to other companies and countries. We call this the ETF XRAY.

Next, consider price momentum looking at 50 and 200 day moving averages. Then consider where top global managers are putting their cash to work and where in the world net cash inflows and country and sector allocations are increasing.

You also need to look at the big picture macro economic factors such as interest rates, currency, fiscal discipline and economic growth rates. The direction and pace of these variables is more important than where they sit right now. Political developments and events such as elections and market economic reforms are also crucial.

Finally, consider technical factors such as point & figure charting as a final check as to timing and to determine where your support levels might be.

Putting in Place a Risk Management System

To manage risk and determine when to sell a position, use a clear and disciplined process. Have a maximum 10% position in any one ETF with a 5% cap for emerging markets. Sell an ETF position if it falls below 200 day moving average or if it falls 8% below its trailing high. Purchase put options on ETFs when available and appropriate. Use modest levels of inverse, sector, precious metal, currency ETFs to buffer your overall portfolio. Rebalance annually to take some gains off the table.

Finally, use the discipline of limiting your portfolio to no more than twenty ETFs. Fifteen ETFs is probably a pretty good number with five 10% positions and ten 5% positions. This avoids the problem of having too many positions in your portfolio since this dilutes the contribution of your best performing ETFs. Having a limit also forces you to sell an ETF before adding an ETF.

Case Study: Brazil

How does this whole process work? Here are two examples for the Brazil (EWZ) and Sweden (EWD) ETFs during 2006.

For Brazil in early 2006 the international fund flows were positive with global equity managers moving to overweight positions and nice net cash inflows. The macro fundamentals were also positive with 3% inflation, foreign exchange reserves $100 billion, $46 billion trade surplus and interest rates high but beginning to fall. The Brazilian companies in the ETF were trading at just over 10 times earnings and the technical chart was also promising. The re-election of President Lula and continued market reforms was anticipated with a fair amount of confidence. The Brazil ETF was up 45.4% in 2006

Case Study: Sweden

In the case of Sweden, the international fund flows were positive and the macro. Fundamentals impressive: strong fiscal discipline, inflation 2%, interest rates slowly rising leading to an appreciating currency. The top ten ETF holdings led by Ericsson (21%) showed nice balance split between capital, technology and banking. The relative valuation of these holdings was only 12 times earnings.

Technical factors were positive with EWD showing solid price momentum. Politically, in the upcoming election, the center-right coalition led by Mr. Reinfeldt based on platform of tax cuts and privatization appeared to have an excellent chance at victory. The Sweden iShare was up 25% during 2006 and is still going strong.

You can see that ETFs as a core investment tool give individual investors the opportunity to build first-class global portfolios that until recently were the purview of only the largest and most sophisticated institutional investors. For example, there is a team of 100 money managers that oversea the Yale University endowment and a sizable staff that oversees the investment process.

Getting Some Help

Identifying patterns that repeat in the futures market, then jumping on them, is what it's all about. These patterns can be rather complex, requiring an accumulated library of observations. The best way to do it is through your own intuition. There's no better computer trading program than your own trained mind.

More S&P 500 Futures Contract Observations:

"A break above the outer band channels on the 1-minute chart is always a good indication of exhaustion and a reasonable place to put on a short position - buy only after a second test failure to make new highs."

Normally, the futures market taps the upper band on each swing and then gently retreats before the next tap. This is with whatever moving bands indicator you use. It means the trend is normal and may continue. BUT when time cycles peak in unison, they have extreme strength out of the ordinary and will rip through this same channel in a climax. Alone, it is just one indication, but combined with other patterns, it can be a powerful signal of exhaustion.

The point here is NOT necessarily looking to short, but to take final profits on your existing long futures position. Remember that if this market had the power to rip through a channel, it obviously was in a bull market of some time frame. A trade-able turn usually needs a double top and a secondary test. This secondary top test destined for a downturn almost never breaks through the channel again. To short this first spike is a premature entry and most tries end in frustration.

My rule for entries is, “the commodity futures market always gives you a second chance to get in.” For example, when looking to get long, price will almost always stab down into the previous highs, giving you a chance to get on board. If not, just let it go.

Chasing futures markets is a bad habit that's tough to break. The reason is once in a while it works and you make a great score, reinforcing sloppy trading. But with patience, most of the time probability lets you have a second chance to get in on a dip. Chasing a market means higher risk and farther away stops when wrong. The funny part about this is the market doesn’t pin medals on those who get the exact first spike bottom. In fact, it usually makes them suffer and sit through double bottoms and spiked lows.

What adds insult to injury is the trader who later buys the second test spike of this bottom is usually IMMEDIATELY rewarded for his patience and control of greed. The market then takes off for the big move right away. It’s not fair, but that’s what often happens. It took me a long time to understand that picking the bottom on the first dive is a loser’s game, even if I am right. The big futures move starts after the second or third test and after you’ve had plenty of time to look at other indications to confirm the projected move. Strange but true..

I have many more S&P 500 futures contract day trading patterns to talk about. For practice until next time, look for the ones we’ve discussed to this point. Look for more articles about market patterns soon.

Good trading!

Identifying patterns that repeat in the futures market, then jumping on them, is what it's all about. These patterns can be rather complex, requiring an accumulated library of observations. The best way to do it is through your own intuition. There's no better computer trading program than your own trained mind.

Here’s some observations from real-time futures trading notes - to give you an idea what to look for:

"If the A-D line (advance-decline line) has been down in the morning and a rally occurs, watch to see if the A-D line does NOT improve much. If it remains 2:1 or worse on the downside at the rally peak, then look to short for a big and long decline into the close. A price peak around the top five minute channel band is a good resistance point to short."

In most cases, you want to be very careful taking a futures trade against the A-D line. It puts the probabilities and power of the market against you. It’s a loser’s attitude wanting to be a hero and catch the big turning point. Of course, there will come a day when the A-D line is very bearish and this is the day when the market turns in a big way and makes a new up-move up lasting many days. But as a day trader, who cares about the BIG turns?

You want to be with the main trend that lasts an hour or so. The "big" turns come every five days or so, so why waste money trying to find them? To make matters worse, there usually needs to be a double or triple bottom lasting all day before the big five-day trend changes anyway. You will get frustrated trying to buy these down days. Just sell the rallies until the A-D line is decidedly bullish. A near 1:1 A-D line is good for chop trading on both sides, but never be caught going long when the A-D line is 2:1 down (or more) bearish.

Observation:

"There is a tendency for the market to have one more push to clean out the longs or shorts before the anticipated move begins. It MUST feel scary. Usually after all the indicators show a bottom or top and the pivot point is not especially sharp, the last fake-out occurs. Another good turnabout indication is a double bottom making a slightly lower low, with little time involved – then reversing up violently. "

Do you know what I’m talking about when I mention the slightly lower low and the futures price violent reversal? Instead of the market continuing into new lows as it had been doing in the decline, it spikes the recent low in one bar and then does a key reversal. The idea is not so much a price key reversal as it is a one-bar TIME wonder that did a search and destroy move.

I envision the big guns knowing it is time to buy, but fail to get much panic follow through to load up. The market simply holds firm at the lows and hesitates. Then all hell breaks loose. They start buying "at the market" for whatever contracts they can get. I can just hear Paul Tudor Jones screaming on the phone to the futures pit, “ Get ANOTHER 1000!… no, make that 2,000 contracts at the market! Did you hear me? 2,000 MORE !!!“ And the futures market responds with offers disappearing as price moves straight up for a few bars.

The market MUST feel scary when you enter or it is a “comfortable trade". A comfortable trade is almost always a loser. Use this as a filter. Get suspicious when thinking of executing a comfortable commodity futures trade. Something is probably wrong. Wait a few minutes and see what happens. It works for me. A friend of mine calls a scary trade a “shaky hand” trade. You get the picture?

In ending, Forex trading is a mounting business. Those of you intending to join Forex in hopes to gain, be, sure to scan open information. Having a full understanding of Forex trading can spare you clamor and aid you in buy and soft soap in Forex?

Forex rigged market works in comparison to other stock exchange markets, i.e. you must have revolving credit, which once you open an account you can start buying pairs or selling pairs in the stock market. Learn about the pairs, since it is important that you know when to buy and sell. You want to learn about bid/ask, as well as pips and spreads in Forex.

If you intend to bank in on Forex, take time to find Forex charts so that you can monitor the market. Forex cabal options often rely on EUR, USD, GBP, JPY, and other pairs of currencies. Right now, the larger currency pairs is the EUR/USD. The US dollar is currently weak, which means that Europe dollar has a greater value. To underpinning your buy on currencies, study the market and focus on the infrastructure currency and price sticker currencies. When you presuppose that the currencies EUR dollar will decline, then you would buy currencies in pairs, such as USD/EUR. Remember however that your best bid is on the EUR currently.

Bear in mind that the Japan Yen is a conveniently cabal stock industry with the US. However, India is also working with the US also, which in time you may see exchanges between these unions. This contends that the larger actions factor into buy or dispose in Forex trading. In outline, Forex trading is a tempt fortune*, touch a nerve ending traders assuming to gain from their currencies.

At the moment, Forex cabal is one of the larger than investment organizations, which currency is exchanged with outer cosmopolitan companies, government, large cyber banking institutes, central banks, financial orgs, and so on. Senders may buy or sell pairs of currency, trading with smaller banks and brokers; however, shopkeepers are at a higher face of loss.

The best chance anyone has in stocks is to play when the spirits are high. When you feel emotionally challenged, then ride out* back, since the no-brainers and lows may not direct in your good. Highs, smallers shift, moving reverse, and forward, so learn preceding you are burned in boards.

Some of the popular stock markets make up Forex, which is the Foreign Exchange Market. Unlike stock markets, Forex when the market is low, your risks of taking a gain are good. In stock market, you have greater risks when buying and selling during lows in the market.

Still, both stock market exchange and Forex uses charts and often base their bids/asks on highs/lows, etc. The difference is Forex bases its logic on trading currencies in pairs, while the stock market sells shares for companies.

Like any venturing scheme, Forex has its risks. Jumping in the stock game is not an option for anyone organic to take right away menaces. Too many hoi polloi* lose in the stock market, so staying well persuasive is the option scarcely you offer to chance into the stock markets.

Stocks, such as Forex trades obsess world currencies, exchange displaies, which wagers are often high stakes. The risks move up per person that couples the corporation. In the Forex market, buy/sell states take the front to other aspects of the market exchange. Yet the high/lows peripheral to the compensate sections on buy/close states. Charts allow you to monitor these states daily. During this maxim, the high/lows can shift; consequently, the stakes could hind-part, rapidly scarring the traders in the stock industry.

For pattern, if the margins in the Forex market have common lots, thenceforth the weight could upbraid at one the privileged to one. This means that the pips in the market are at the lowest rates, which is commonly 1 percent. To traders this marks the standards of pips at rates insufficiently at $10, i.e. per unit and at the rates of 100,000.

The dells utilize "hoop lots." The cornucopia gives traders flexibility in the stock exchange. The value of Forex pips at one buck at units of 10,000 could adjust at swimmingly per lot at averages of one hundred to one.

The pip value could lead to one goat, yet the magnitude of the lots is what brokers' temporary agency on. Still, if the lots size flexes, it could free no problem* access for operators in the market to identify with indentures size based no their own mazumas, which could be $1 low.