Avoiding Contradicting Exposure in a Portfolio

portfolio-exposureSimilarly to how it is that a personal investor needs to be on the lookout for redundant risk exposure in their portfolios, there are several similar situations that arise which will create conflicting risk exposure in the portfolio. While there is plenty to be said for taking on positions that reflect both position directions of market movements through carefully analyzing competitors for long/short strategies, it is important to remember that positions that directly contradict each other will make a portfolio inefficient, and should therefore be avoided.

A conflicting position in a portfolio means that there are two securities being held that will almost perfectly negate each other. It is the equivalent of going long against a given security, and then shorting it at the same time within the same portfolio (aka “shorting outside the box”). Because these two positions would effectively contradict each other, any movements in that underlying security would create no gains or losses, and would only type up portfolio capacity. Extending this circumstance then into a more realistic situation, we can start to see how it is that an active investor that works with both bearish and bullish mutual fund and ETF positions might come into a portfolio that creates partially conflicting investment positions.

Active investors will commonly take their portfolios to the next level of sophistication by introducing aggressive sector rotational exposure to their portfolio. If the investor has access to large amounts of capital, this can be accomplished by directly purchasing and short selling specific securities based on their given sector, and the current market cycle. That being said, personal investors do not generally have access to the vast amount of wealth required to pursue this sort of strategy.

As such, they will generally rely on inverse and even leveraged ETF positions to create similar exposures. While these inverse ETF positions will still serve their intended purpose very well for an informed investor, it is important to remember how it is that the degree of diversification within these funds might be detrimental to the overall objectives of the position if it is creating contradictory exposure.

This sort of conflicting investment commonly occurs when an investor takes out an inverse position that is diversified throughout 50+ companies inside an ETF. However, upon doing so, the investor fails to realize that the inverse position is negatively positioned against an equity that they are holding directly in their portfolio, or indirectly through another fund position. For example, if an investor were to try and hedge out the market’s macroeconomic risk by purchasing an inverse position on the S&P 500, but still held a mutual fund that served to act as a strong equity backbone for a greater personal portfolio, it may be that many of the positions in the long backbone position are being cancelled out by a negative counter-part in the short portfolio. The end result is an inefficient portfolio that is working against itself.

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