Like never before, America is awash in cash and bonds.

Ask yourself why. It's not because investors are in love with 1.5% CD yields or the current outlook for bond returns. Now that yields on 5-year Treasuries have declined by 75 basis points since mid-June, while the Fed has raised rates twice, bonds have never looked more vulnerable. According to JP Morgan Economic Research, the current 1.75% Fed funds target rate is forecast to rise to 4.25% by December of 2005. In that scenario, bonds are a long shot to break even on a total return basis.

In one word, here's why money has piled up in safe havens?inertia. Most financial advisors haven't offered any other solutions for hedging stock market risk. Now, you can offer your clients an interesting new asset class enabled by financial innovation: "short-the-market."

Look at your book and tally all assets in cash and bonds. If you could bring just one-third of that money into equities in 2005, how much would your revenues increase? Short-the-market strategies do not make sense for all clients in all market environments, for reasons discussed in this article. But they may make sense for at least part of your clients right now.

The Four Elements of "Short-the-Market"

To add a "short-the-market" asset class in a sensible way, you need four elements:

1. A margin account.
2. A long-term asset allocation program that includes actively managed equities–e.g., individual stock portfolios, equity mutual funds, equity variable portfolios, or separate accounts. (All actively managed equities need not be held in the margin account; some can be qualified assets; for example, in a 401(k) or IRAs.)
3. A conviction that the active equity managers whom you have chosen for clients have a good shot at beating benchmarks, such as the S&P 500 Index.
4. A reliable way to execute the strategy by shorting a broad market index. Fortunately, several Exchange Traded Funds (ETFs) now offer that solution.

To illustrate how short-the-market works, imaging counseling a client who currently participates in a "moderate" allocation model with 20% in cash, 30% in bonds and 50% in equities.

You approach this client and say: "Your cash is not adding much return right now, and I'm worried about bonds in a rising-rate environment. So, I have another idea that will help you pursue the same objectives with similar risk:

• Put 100% of your portfolio in actively managed equities, instead of just 50%.
• Add another 25% in a 'short-the-market' asset class."

Then, you tell the client: "You participate in this asset class by putting some of your (taxable) actively managed equities into a margin account, to serve as collateral. You then sell short a broadly-based index ETF, such as SPDRs, which track performance of the S&P 500 Index. The shares you are short will equal 25% of the market value of the equities you are long, and these shorts will be long-term holds, just like your equities. You are able to exceed 100% of your assets in this allocation because the ETF shares you sell short are borrowed. Your portfolio is modestly leveraged at 125%, but its risk profile is similar to 20% cash, 30% bonds and 50% stocks. Let me show you why."

Your current portfolio ("Portfolio 1″) is shown above the horizontal line, which measures the correlation of asset classes with a broad stock market benchmark, such as the S&P 500 Index. Cash has a zero correlation, and bonds have a modestly positive correlation. Your equities have a strong positive correlation, close to 1.0. The proposed portfolio ("Portfolio 2″) is shown below the line. By definition, your short-the-market position has close to a perfect negative correlation with a broad stock market benchmark. That means a dollar allocated to this class has twice the ability to hedge market risk as each dollar allocated to cash, and more than twice each dollar allocated to bonds. Imagine that you take 25% of your equities and put them into a bucket along with short-the-market. Now, 50% of assets are nearly "market-neutral," which means they will have about the same zero correlation as cash. However, you have 125% invested. So 50% of 125% means you have about 40% of total portfolio value in a 'cash-equivalent.' (50% divided by 125%) The combination of 40% in cash-equivalents and 60% in equities has nearly the same risk profile as 20% cash, 30% bonds and 50% equities."

The market-neutral part of Portfolio 2 is "cash-equivalent" not only in terms of risk but also in terms of potential return. In the example above, this portfolio will achieve a positive return to the extent that active equity managers outperform the benchmark index, net of management fees and expenses. But because half of the market-neutral position is created with borrowed money, any outperformance (or underperformance) is doubled for purposes of measuring return on cash invested.

Example: Active managers earn a 10% net return during a year when the benchmark returns 8%. The difference is 2%, but the return on cash is 4%. This explains why you must believe active managers can beat the benchmark for this strategy to make sense. (Note: This is sometimes called a "Double Alpha" strategy, because the value that active managers create is doubled in the market-neutral part of the portfolio. Also note that on the other 75% of equities outside the market-neutral part, the strategy remains "Single Alpha.")

Some clients may not be able to understand this explanation, and others may have an aversion to margin and short-selling because they associate it with trading and speculating. But in this strategy, the short-the-market asset class is a long-term buy-and-hold that serves to reduce overall portfolio volatility and risk. The only reasons to change the short-the-market allocation include: 1) adjusting the level of overall portfolio risk (more shorts = less risk); or 2) rebalancing the portfolio. Rebalancing with short-the-market is relatively easy because only one side of the portfolio needs to be adjusted. Just keep the short-the-market side at the pre-determined percentage of the long side (e.g., 25% in the example above).

Advantages of Shorting ETFs

The popularity of ETFs has made this strategy feasible for individual investors, for several reasons:

• Liquidity – Two ETFs listed on the Amex trade more than a billion shares per month and are actively used by institutions in hedging long equity portfolios, as shown in their large short interest. The table below summarizes statistics on trading volume and short interest on four ETFs for September of 2004. You can obtain detailed current and historical statistics on Amex-traded ETF volume and short-interest at: www.amex.com/amextrader

In this article, Gastineau quantifies the "net interest rate spread" for shorting SPDR ETFs at about 10-30 basis points per year. (This spread represents the difference between interest credited on short sale proceeds and interest charged on margin loans. In addition to paying this spread, short sellers also are liable for paying the cost of dividends.)

A Performance Model

To test the potential advantages of a "short-the-market" asset class, we created a model that compares Portfolio 1 and Portfolio 2 in four different market scenarios. The two portfolios are as follows:

• Portfolio 1: 20% cash, 30% bonds, 50% equities.
• Portfolio 2: 100% equities and 25% short-the-market.

The four scenarios were: 1) strong up stock market; 2) modest up stock market; 3) modest down stock market; and 4) strong down stock market. In all cases, it was assumed that actively managed equities outperform the benchmark by 2% net of fees and that ETFs exactly track benchmarks. In reality, as Gary Gastineau's research has shown, ETFs tend to lag benchmark performance by a small amount that represents their management fees and cash holdings. This lag works to the benefit of ETF shorts used in hedging strategies, helping to offset the "net interest rate spread" and dividend costs of short positions. Our model ignores all such costs in Portfolio 2, assuming they wash out when compared to similar costs in Portfolio 1 (e.g., bond fund management fees and expenses).

The table below shows hypothetical performance for each asset class and the two portfolios under each scenario. Note that the model does not include a scenario in which bond performance is strong, because it assumes that as interest rates rise, the short-the-market position will gradually be liquidated and replaced with bonds.

In summary, the model indicates that Portfolio 2 could perform a bit better than Portfolio 1 in up markets and a bit worse in down markets. Keep in mind that historically over the past 50 years, the stock market has been up 75% of all years and down 25%. In non-qualified accounts, when taxes are considered, Portfolio 2 might be expected to outperform on an after-tax basis by perhaps 2% annually, assuming active managers are somewhat successful versus benchmarks. This also assumes that the "short-the-market" position is gradually reduced and bond exposure is increased as interest rates rise (and vice versa as rates decline).

Note that the value provided by active managers is constant in both portfolios. However, that value is magnified in Portfolio 2 because of the Double Alpha component.

How to Apply This Idea

Many clients won't understand how shorting-the-market can make their portfolios less volatile and risky. So, you might want to set up a fictional "shadow portfolio" to show them how a combination of long equity managers and "short-the-market" performs. They will see how the shorts dampen volatility and hedge risk day-by-day and month-to-month. Then, they can then decide if this is a comfortable level of risk.

The short position doesn't need to create pure market neutrality with long managed equities. For example, the Nasdaq-100 tracking ETF (QQQ) tends to be somewhat more volatile than the market as a whole. Taking about a 15% to 20% short position in the QQQ could have the same risk-reducing effect as putting 25% into short SPDRs. Also, QQQ component stocks represent 15%-20% of the S&P 500 Index's total market cap. So, shorting the QQQ with this percentage (of the long position) would have the effect of offsetting virtually all the high-tech volatility contained in a typical large-cap growth mutual fund or separate account. (This is not purely a market-neutral strategy because it will under perform when tech stocks are relatively strong and over perform when tech stocks are weak.)

In Summary

Many financial advisors have strong convictions about the skills of the active managers they select. If you are among them, the "double Alpha" strategy described in this article is a way to let your clients increase participation in active managers without assuming more overall portfolio risk. Also, this strategy is a way to help your clients participate in bonds during periods in the rate cycle when they are attractive, while avoiding them when they aren't. It also can potentially eliminate the "dead money syndrome" and tax impact of holding cash when the main motive is risk-reduction, not liquidity or income.

Clients who understand margin accounts are the best candidates for this strategy. Among sophisticated clients, this strategy also can reduce pressures to expand into "alternative" investments. "Market-neutral" is a viable alternative strategy?actually one of the oldest and most pure?and short-the-market allows advisors to stick with long equity managers whom they know and trust, instead of leaping for new and unproven hedge fund managers and all their business risk and lack or transparency. Many clients will feel confident increasing their assets under management with familiar, proven managers once they understand how short-the-market allows them to hedge overall portfolio risk with a high degree of personal control.

Tax Strategies with Short-the-Market

You probably should obtain your own tax advice before recommending a short-the-market strategy. Here is a basic tax overview that can help:

• Long-term short positions. A short position that exists for more than a year qualifies as a long-term capital gain or loss, with a caveat. The brokerage firm may report on Form 1099-B that the investor has sold stock when the position is opened. If the position is still open at year-end, the investor should attach a note to the 1040 indicating this. The IRS will not impose tax until the short is closed.
• Constructive sales and short sales against the box. These complex rules should not apply in the hedging strategies described above, since ETFs are not the same or "substantially identical" to the long equities being hedged. Be sure to avoid holding long the same ETFs used in short hedging.
• Tax-loss harvesting. In years when the market rises, short ETFs will produce a loss. This can be "harvested" in the same year by closing the short position and immediately establishing a similar hedge using a different ETF. For example, you could close a hedge position in SPDRs and immediately open a new one in Diamonds. (They are not considered "substantially identical.") Any losses harvested can be used to offset capital gains and up to $3,000 per year of ordinary income.
• Dividends. Short sellers must repay to the brokerage firm that loans ETF shares any dividends paid to longs. If the short position is held for 45 days or longer, these payments may be deducted as investment interest expense on Schedule A.

For details, see the TurboTax article on short sales taxes here:

• http://www.turbotax.com/articles/SellingYourStocksShortTaxEffects.html