On a related note: I once landed a job considerably better than I thought I would, and was afraid the company might go bankrupt. I was considering buying some puts on it to hedge my exposure, but realised this was probably a bad idea; I would have to disclose my holdings as part of the job, and they would be unlikely to take kindly to my having a massive short position on them. Is there a better way I could have done this?
Well, first, I think that there are ethical issues in trying to hedge your risk from employment. Your risk exposure is beneficial to the company, and the employment is made with an expectation of it. If I hired a lawyer on contingency, and found out that they managed to hedge out all of the risk of losing the case, I would find this behavior quite unethical, to say the least. An employee should not be indifferent to the bankruptcy of their employer.
The being said, there are informal ways of hedging this risk. The biggest is having a social network of people who support each other through times of unemployment. While families are often in the same line of work, from a risk management point of view it’s best to diversify. Besides the other issues, having a spouse that works at the same company as you is quite dangerous if the company runs into financial difficulties. (However, I don’t expect to see many personal ads along the lines of “SWM working in bio engineering field seeks SWF in anti-correlated field”.) And obviously, buying stock in the company increases your risk and should only been done if your company compensates you for doing so (such as offering free/discounted stock options). If you are offered stock option, the rational, although perhaps not most loyal, course of action is to sell them as soon as you can.
I never actually read the details of the disclosure requirements, but it would be strange to demand disclosures of stock but not of options, especially as the later would be more useful to someone seeking to do intersider trading (hence why spreads are, ceteris paribus, wider in options markets), while stocks are more conducive to a long term buy-and-hold strategy.
They vary a lot, so I’ve never bothered looking into the specific rules around it. I suspect you’re right, of course(though CDS bets may be a viable loophole), but I figured it was a question worth asking.
This is unlikely to be a good strategy, because competitive stocks are usually correlated, and market participants see the bankruptcy of one company as possibly foretelling a weak market for the competitors’ products also. Unless it’s a very specific and unusual situation.
In fact, some think it is best practice for people whose future earnings are highly correlated with a particular market sector to reduce any stock ownership they have in that sector to reduce their risk. E.g. software developers should have portfolios that underweight software or technology. It has theoretical support, but hardly anyone in the real world does this because of the added complexity as compared with buying index funds and because of outdated thinking around retirement planning.
It’s even harder to do when you’re young and your portfolio is 100% cash (and human capital).
Is there a reason a company doesn’t offer S&P- products—S&P minus a specific industry. If the bank diversified their customer they could just buy straight index funds and then distribute the returns differentially.
Sector ETFs are already pretty inexpensive on an expense ratio basis. Vanguard’s sector ETFs for example have expense ratios of 0.14%, which compares with an expense ratio of 0.05% for the cheapest S&P500 ETF. A bank wouldn’t be able to do it any cheaper, realistically. Someone could offer ETFs that exclude particular sectors, but it just hasn’t been done, and I still don’t think it would be cheaper because of economies of scale for the funds that currently have the most capital.
You do have to have a certain amount of capital to successfully diversify using ETFs, obviously, but the bank doesn’t really care about you either if you aren’t investing at least a few thousand.
This is a very good point.
On a related note: I once landed a job considerably better than I thought I would, and was afraid the company might go bankrupt. I was considering buying some puts on it to hedge my exposure, but realised this was probably a bad idea; I would have to disclose my holdings as part of the job, and they would be unlikely to take kindly to my having a massive short position on them. Is there a better way I could have done this?
Well, first, I think that there are ethical issues in trying to hedge your risk from employment. Your risk exposure is beneficial to the company, and the employment is made with an expectation of it. If I hired a lawyer on contingency, and found out that they managed to hedge out all of the risk of losing the case, I would find this behavior quite unethical, to say the least. An employee should not be indifferent to the bankruptcy of their employer.
The being said, there are informal ways of hedging this risk. The biggest is having a social network of people who support each other through times of unemployment. While families are often in the same line of work, from a risk management point of view it’s best to diversify. Besides the other issues, having a spouse that works at the same company as you is quite dangerous if the company runs into financial difficulties. (However, I don’t expect to see many personal ads along the lines of “SWM working in bio engineering field seeks SWF in anti-correlated field”.) And obviously, buying stock in the company increases your risk and should only been done if your company compensates you for doing so (such as offering free/discounted stock options). If you are offered stock option, the rational, although perhaps not most loyal, course of action is to sell them as soon as you can.
Also most companies have explicit policies against it.
Would you have had to disclose a put option position, or a credit default swap?
I never actually read the details of the disclosure requirements, but it would be strange to demand disclosures of stock but not of options, especially as the later would be more useful to someone seeking to do intersider trading (hence why spreads are, ceteris paribus, wider in options markets), while stocks are more conducive to a long term buy-and-hold strategy.
They vary a lot, so I’ve never bothered looking into the specific rules around it. I suspect you’re right, of course(though CDS bets may be a viable loophole), but I figured it was a question worth asking.
Buy shares in competing companies, maybe?
This is unlikely to be a good strategy, because competitive stocks are usually correlated, and market participants see the bankruptcy of one company as possibly foretelling a weak market for the competitors’ products also. Unless it’s a very specific and unusual situation.
In fact, some think it is best practice for people whose future earnings are highly correlated with a particular market sector to reduce any stock ownership they have in that sector to reduce their risk. E.g. software developers should have portfolios that underweight software or technology. It has theoretical support, but hardly anyone in the real world does this because of the added complexity as compared with buying index funds and because of outdated thinking around retirement planning.
It’s even harder to do when you’re young and your portfolio is 100% cash (and human capital).
Is there a reason a company doesn’t offer S&P- products—S&P minus a specific industry. If the bank diversified their customer they could just buy straight index funds and then distribute the returns differentially.
Sector ETFs are already pretty inexpensive on an expense ratio basis. Vanguard’s sector ETFs for example have expense ratios of 0.14%, which compares with an expense ratio of 0.05% for the cheapest S&P500 ETF. A bank wouldn’t be able to do it any cheaper, realistically. Someone could offer ETFs that exclude particular sectors, but it just hasn’t been done, and I still don’t think it would be cheaper because of economies of scale for the funds that currently have the most capital.
You do have to have a certain amount of capital to successfully diversify using ETFs, obviously, but the bank doesn’t really care about you either if you aren’t investing at least a few thousand.