Advanced Investing Concepts
Beyond the standard approach to portfolio management and asset allocation, there are a number of advanced investing concepts which involve using sophisticated strategies and complex instruments. These are typically used by more experienced investors in order to enhance their portfolio management process. In this chapter, we will explore derivatives, leveraged and inverse ETFs, and hedge funds, discussing their characteristics, benefits, and risks.
Derivatives
Derivatives are financial contracts whose value is derived from an underlying asset, such as stocks, bonds, commodities, or currencies. These are used by professional investors to offset specific risks within a portfolio or to speculate on short-term price movements.
Types of Derivatives: Common derivatives include futures contracts, forward contracts, total return swaps, and options.
Uses of Derivatives: Derivatives can be used to hedge financial positions, speculate on asset prices, or use funds more effectively through margin.
Risks of Derivatives: Derivatives can be risky due to counterparty risk, changing market conditions, and the inherent complexity of using these products.
Leveraged and Inverse ETFs
Leveraged and inverse ETFs are exchange-traded funds that use derivatives to magnify your exposure to a particular index or asset. Due to this leverage, they offer the potential for significant gains but also come with higher downside risks.
How They Work: Leveraged ETFs utilise derivatives to magnify their exposure to a target asset, often tracking daily changes and resetting at the end of each trading day.
Benefits and Risks: Leveraged ETFs offer the potential for significant gains but come with higher fees and expense ratios due to the difficulty in managing the instruments, along with the risk of substantial losses.
Inverse ETFs: Inverse ETFs attempt to make money when the underlying index declines, allowing investors to profit from a bearish market, which can be useful when hedging a portfolio.
Hedge Funds
Hedge funds are pooled investment vehicles that can invest in various products, including derivatives, foreign exchange, and publicly traded securities. These are traditionally used by sophisticated and institutional investors due to their uncorrelated returns and ability to generate returns from the market going up or down, helping to diversify a portfolio.
Characteristics of Hedge Funds: Hedge funds are diverse in structure, as they employ various investment strategies simultaneously and may concentrate their portfolios along with using leverage to try and achieve higher returns above an index, while also aiming to reduce their overall volatility and risk.
Investing in Hedge Funds: Investment in hedge funds is most suited to sophisticated and institutional investors with larger portfolios, expertise, and capacity to manage the underlying risks of this specific investment type.
Funds of Hedge Funds: Funds of hedge funds provide a cost-effective means for smaller investors to gain exposure to the underlying performance of hedge funds, but they are managed by an independent fund manager, allowing for robust due diligence and policies to assess liquidity risk.
Conclusion
It is important to understand the different advanced investing concepts and strategies that are available to experienced investors and how these can further enhance their approach to investment management. However, you should remember that these instruments are not appropriate for all investors, as they come with higher risks and complex management requirements, so they need careful consideration and a thorough understanding before implementation. In the next chapter, we will summarise the key takeaways from our Introduction to Investing guide and the next steps you should take in managing your portfolio.