How to hedge your portfolio
Recent history shows that stock market crashes and bear markets happen on a fairly regular basis, but investors can mitigate these losses through hedging.
Recent history shows that stock market crashes and bear markets happen on a fairly regular basis, but investors can mitigate these losses through hedging. Here we discuss the types of hedging as well as the metrics to consider when evaluating hedging solutions.
Managing volatility
Managing volatility
The extreme volatility experienced by financial markets this year reminds investors of the importance of hedging, as equity drawdowns can quickly wipe out years of gains. We believe hedging should play a critical role in portfolio construction, as a solid strategy could reduce drawdowns, shorten recovery time and ultimately give investors the freedom to add risk during market recoveries.
To properly evaluate and compare hedging solutions, we think traditional indicators like volatility or risk-adjusted returns are not enough. We believe investors should also consider the costs and reliability of a hedging instrument, as well as its sensitivity to market drops. We therefore developed an easy-to-apply hedging scorecard based on three metrics: sensitivity, costs and consistency. These metrics help us identify strengths and weaknesses of each hedging instrument and should be carefully evaluated by investors who are looking for a protection strategy.
In our analysis, we classify hedges in two major categories:
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Hedge to increase risk?
Hedge to increase risk?
Interest rates are at historic lows. Over USD 17 trillion of global debt had a negative yield as of September 2020. As a consequence of this low interest rate environment, returns on more risky asset classes will be lower than in the past.
Investors may need to increase allocation to risky assets, such as equities, in order to meet their required return target. An investor with a classical 60/40 portfolio, with 60% allocated to equites and 40% to bonds, might look to increase the equity allocation within her portfolio. A higher allocation to equities will not only increase the expected return of the portfolio, but also increase the risk of the portfolio.
While an increased equity allocation should achieve higher returns over the medium to long term, the additional risks can be more challenging over shorter time horizons. In particular in challenging market environments, such as in March 2020, it may be demanding to remain invested and keep a high equity allocation.
Increasing equity exposure, but simultaneously partially hedging it, provides a viable alternative. For example, an investor could choose an 80% exposure to equities, of which she could hedge 50%. The hedged portion of the equity allocation would achieve a lower return in upward trending markets, as option premiums need to be spent in order to protect the equity portfolio. But it will suffer less in adverse market environments.
Hedging and diversificationÌý
Finding the best hedge for the next market downturn may be challenging—what worked well during one risk-off shock may not provide the best protection during a different event. In our view, the concept of diversification should be extended from traditional portfolio construction to hedging. With the help of our scorecard, investors can select the most suitable combination of hedging instruments optimized for protection, consistency and costs.
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