Passive Indexing Alternatives | Part 1: Hedge Instead Using ETFs Such As VTIP

What is the best alternative to do-it-yourself, active investing?

The financial media suggests investing in passive indexes to guarantee that portfolios keep pace with the market. So what is the worst choice?

Joining the crowd and trading the shortsighted gimmicks churned by the Wall Street fee machine is inferior to buy-and-hold passive indexing and active common stock investing.

Nevertheless, it is typical for the proponents of passive investing to omit a reminder that indexes contain every company in the market, sector, or industry, translating to owning lots of poor-quality enterprises in addition to the few good ones. Thus, thoughtful investors limit the holding of index exchange-traded funds [ETFs] to hedging the common stocks in their portfolios with designs to achieve alpha over time.

This two-part series explores the general concept of portfolio hedging — albeit on the long side — and why it is essential to any active, long-term investment strategy.

Part one focuses on hedging a common stock portfolio against inflation.

Using Passive Index ETFs to Hedge a Portfolio

Index ETFs provide retail investors with passively managed funds of publicly traded equities or fixed-income securities.

Although safer, in theory, than individual stocks, passive index ETFs carry the shared risks of any equity investing, including the permanent loss of invested capital because of fund company failures, irrational market sentiment, negative financial news, or black swan events.

In addition, passive indexing assures average returns to the market, for better or worse. However, index ETFs tend to be less vulnerable to volatility and market liquidity than individual stocks. Thus, an ideal investing purpose for index ETFs is a portfolio hedge against a basket of related or conflicting individual stocks regarding market, industry, or capitalization.

When used for hedging, passive index ETFs offer longer-view retail investors the opportunity for strategic diversification toward a safer portfolio. However, diversification presents a two-edged sword, leaving the over-diversified common stock portfolio best served by transitioning to passive indexing to lessen risk and lower costs.

In contrast, concentrated portfolios of the common stocks of select quality companies — hedged by distribution-paying ETF compounders, each purchased at reasonable prices — provide the most promising opportunity for success for long-term retail investors.

Suggesting that an active individual investor go 100 percent index funds is akin to recommending that an avid angler buy every fish at the market.

Funds cannot assure that each enterprise in the basket carries the investor's desired qualitative parameters. Buying individual common stocks gives retail investors more control over the quality of the holdings in their portfolio. Nevertheless, even a well-planned and executed long-view value-driven portfolio must hedge against the inevitable ups and downs of market cycles.

The daily news rotation and quarterly earnings reports drive the speculators to buy, sell, and short recklessly. Be on guard against the unpredictable, although inevitable, external threats to portfolio holdings.

Whether used for active or passive investing, exchange-traded funds or ETFs are derivatives notorious for inherent risk from massive investor participation. Warren Buffett of Berkshire Hathaway (BRK.A, BRK.B) has said that makes them candidates for "financial weapons of mass destruction" [1] in a down market.

Therefore, the defensive hedge positioning of choice is the secondary use of indexed exchange-traded funds.

Look to Vanguard Group for ETF Hedges

Because beating the market or achieving alpha is the Achilles' heel of active investors — including the Wall Street money manager elite — consider hedging a portfolio on the long side using low-cost indexed ETFs tracking the relevant benchmarks.

Of note, index ETFs do have lower fees on average than mutual funds. Thus, thoughtful investors enhance the risk/reward proposition by hedging with a suitable ETF.

On occasions, I have deployed three ETF hedges in our family portfolio: Vanguard Short-Term Inflation-Protected Securities Index Fund ETF Shares (NASDAQ:VTIP), Vanguard FTSE All-World ex-US Index Fund ETF Shares (NYSEARCA:VEU), and Vanguard S&P 500 ETF (NYSEARCA:VOO).

Hedging with the short-duration bonds of U.S. Treasury inflation-protected securities, such as Vanguard's VTIP, with the stocks of non-U.S. companies, such as Vanguard's VEU, and with the S&P 500 (SP500) as represented in Vanguard's VOO, allows retail investors to keep pace with the voting machine turbulence of the market in the short-run.

Then, focus confidently on the weighing machine's compounding of capital gains and dividend payouts over time. Each is an excellent choice to hedge against periods when those distinct market conditions outperform a basket of select common stocks.

I choose Vanguard for ETF hedges because, as a mutual-owned enterprise, it is immune to answering independent stockholders or outside owners. The objective of Vanguard is to manage each fund at cost, allowing investors to keep more of the returns. The benefits of Vanguard align with the three primary investment objectives of Quality Value Investing (QVI).

• Limited capital: Vanguard's publicly traded ETFs have no criteria for investment minimums beyond the price of one share.
• Lower costs: When writing this article, VTIP carried an annual expense ratio of just 0.04 percent; VEU was a respectable 0.08 percent; and VOO was the lowest at 0.03 percent. Investors pay pennies for the occasional ETF trade using a commission-free online discount broker.
• Less risk: VTIP, as a short-duration government bond fund, carried a low-risk rating; the international exposure of VEU earned an average-risk rating; and VOO, as a domestic stock market benchmark, also had an average-risk rating.

(Source of ETF ratings: Morningstar.)

The mutual ownership approach to the investment products at Vanguard satisfies the crux of the mantra of QVI in building and maintaining portfolio wealth with limited capital, lower costs, and less risk. The three highlighted ETF hedges each pay distributions — the cumulative quarterly equity dividends or bond yields, plus occasional capital gains from the holdings in the ETF — and offer low portfolio turnover.

Disciplined investors own slices of quality companies hedged with passive index ETFs through low-cost, online discount brokers and mutual investment companies like Vanguard.

VTIP: Protection Against Inflationary Cycles

Although deflated interest rates were a boon for equities in the 2009 to 2021 bull market, the ongoing threat to the stock market is inflation — the annualized spike in goods, services, and interest rates.

Contrarian-minded value investors think of hyperinflation as the third worse menace to the market after high fees from the financial services industry and illogical investing sentiment from the crowd.

Inflation-protected securities, such as VTIP, offer protection against hyperinflation as a potential stock market killer, producing a bounty for the quality-driven value investor. In addition, short-duration bonds aim to provide lower real interest rate risk over several market cycles until acute inflationary pressure rears its head.

Nonetheless, we have limited control over trader and investor behavior beyond ignoring irrational investing or divesting by the herd except to take advantage of their uncanny ability to produce mispriced value stocks.

On the contrary, protecting our portfolios from unexpected inflation spikes is possible.

Vanguard Short-Term Inflation-Protected Securities Index Fund ETF

Here is a summary of VTIP:

Vanguard Short-Term Inflation-Protected Securities ETF is an exchange-traded fund launched and managed by The Vanguard Group, Inc. The fund invests in the fixed-income markets of the United States. It primarily invests in inflation-protected public obligations of the U.S. treasury with remaining maturities of less than five years. The fund seeks to track the performance of the Bloomberg U.S. Treasury Inflation-Protected Securities (TIPS) 0-5 Year Index by using a full replication technique. Vanguard Short-Term Inflation-Protected Securities ETF was launched on October 12, 2012, and is domiciled in the United States.

• ETF Ticker: VTIP
• Yield: 5.10%
• Morningstar Overall Rating: Five Stars
• SA Analysts' Consensus Rating: Buy
• SA Quant Rating: Sell
• Wall Street Rating: Not covered

(Source: Seeking Alpha Premium.)

Because of historic low-interest rates and deflation, TIPs — Treasury inflation-protected securities — were a non-story in the post-Great Recession bull market. Typically, disciplined investors know the best time to buy inflation hedges, regardless of the vehicle of choice, is when inflation is off Wall Street's radar. Moreover, traditional inflation hedges had become less expensive as the fast money gobbled up forward high-yield dividend stocks, non-dividend growth plays, money-losing tech start-ups, and zero utility cryptocurrency.

This article is perhaps a simple exercise in value investing because investors loaded up on inflation-protected products en masse, whether short-duration bonds, precious metals, or real estate, at much higher entry prices as hyperinflation and increasing interest rates struck during the 2022 bear market. The lesson is that the best time to buy inflation hedges is when they're a non-story.

What about diversifying a retail portfolio with other fixed-income products like bonds or bond funds?

Throughout the second decade of this century, the mainstream financial media reported that intermediate and long-duration fixed-income debt instruments — government or corporate-issued bonds, bills, or notes — were a bubble waiting to burst. The extended bull market in bonds dated back to the 1980s, ground zero for borrowing our way to prosperity in America, whether government, business, or household. This self-defeating economic insanity continues over forty years later.

Whether in business or at home, debt accumulation is the most significant threat to our financial security. Strategic debt is beneficial for building foundations in our professional or personal lives, whereas indebtedness to finance an immediate sense of prosperity is often a death knell.

In the QVI Real-Time Portfolios, which includes our concentrated family portfolio, I favor equity ownership over lending by investing in stocks instead of bonds. However, I also accept that using short-duration Treasury bills as a hedge plays a crucial role in helping to protect the portfolio against the perils of hyperinflation when it occurs.

Although the best time to buy an inflation hedge is during low-inflation markets, I agree with the SA Analysts' consensus that VTIP remains a buy to protect common stocks from rising prices and interest rates over the portfolio's life.

Active and Passive Investing in One Approach

Employing an invest-it-and-forget-it style is an ideal variant for passive S&P 500 or other index investors.

I advocate for thoughtful, disciplined, and patient investors who want to merge the lower cost and lesser risk of passive investing — via hedging — with the potential for above-average returns from active buy-and-hold investing in companies with high-quality business models when their shares are trading at reasonable or bargain prices. Active investors enjoy stock-picking and portfolio management through rigorous education and applying common sense.

Although hedging is a complex paradigm of investing, in the context of this article, it represents a simple long position in a portfolio, such as VTIP or similar index exchange-traded fund (ETF), to reduce the risk exposure of common stocks from the inevitable market gyrations, including the negative impacts of inflation and rising interest rates as portfolios experienced last year.

In my 14 years of quality-driven value investing using an active approach to stock picking hedged by passive indexes — such as short-duration inflation-protected securities — I have discovered that achieving alpha or outperforming the market over the long term is possible on Main Street and is an enjoyable and self-actualizing experience.

Next: Part 2 of this series submitted to the Seeking Alpha Editors further explores hedging with VEU and VOO and why buying the value stocks of quality companies is an ideal path to building portfolio wealth.

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1. Warren E. Buffett, Berkshire Hathaway, Inc., 2002 Letter to Shareholders, February 21, 2003, 15.

Copyright 2023 by David J. Waldron. All rights reserved.

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