Hedging is one of the most effective investment strategies when it comes to managing portfolio risk and achieving balanced returns
While it’s easy to adopt a ‘set and forget’ approach to investing, that strategy can fall short when bouts of volatility begin to emerge in the market. And as we’ve seen in recent weeks, whether it’s the escalating threat of a conflict in the Middle East, the prospect of a Coronavirus pandemic, or any other major risk event for that matter, it is important to have a flexible and responsive investment strategy.
This is where hedging comes into the fold, which is a form of risk management designed to offer ‘protection’ from unforeseen events. Just as you would buy travel insurance before you take off on a holiday, or purchase car insurance before you drive a vehicle on the road, these measures are hedging initiatives designed to safeguard your financial position and reduce the impact of any negative event that might take place.
Not only does hedging represent an invaluable investing strategy that effectively limits downside risk to your holdings, it can also simultaneously provide you with exposure to any broad fall in the market. The extent of such exposure depends on how you achieve a hedging outcome, with various means to do so.
Utilising hedging for individual stocks
The principle of hedging relies on being able to acquire financial instruments, be it equities or derivatives, that hedge against one or more of your current holdings. Ideally, the consequence of acquiring those financial instruments should be an outcome that offsets movement in the underlying holding(s). While many people assume that this means you should buy an instrument that is perfectly correlated to the underlying holding(s), this doesn’t need to be the case.
Nonetheless, if you are looking for specific downside protection for a stock, you could opt to buy put options relating to that specific company. Therefore, if the stock were to fall, provided it occurs within the timeframe you seek coverage for, you would have the right to sell an agreed amount of shares in that company at a pre-determined price that you agree to. Alternatively, where a company’s primary operations are dependent on commodity prices such as gold and oil, you may consider buying or selling commodity-related put options.
While these measures can both prove to be an effective hedging strategy for an individual holding, if you need to replicate such protection over an entire portfolio it can be cumbersome and more costly, since you pay a premium to acquire each put option.
How can hedging be achieved across a managed portfolio?
Where risk and volatility extend more broadly to the entire market, and you want to hedge across a managed portfolio, there are other options at your disposal. You could decide to buy a put option against one of the key indexes, or you could buy an inverse ETF. You may even choose to sell ‘short’ the index.
However, selling futures contracts is another popular hedging strategy commonly used to protect the value of a portfolio, and it is one approach that we actively use at Kauri Asset Management. This strategy involves us selling E-mini S&P 500 futures contracts to the same value of our clients’ portfolios.
Futures contracts involve buying or selling the index at a fixed date in the future for a specified price. However, futures contracts possess a few very important distinctions from options. The first is that a futures contract is an obligation to buy or sell that asset, rather than just the ‘right’ to do so. Secondly, performance of the contract only takes place at the specified date, whereas with options this can occur beforehand.
Another thing to note is that we also manage portfolio risk through currency hedging. This is because our accounts are typically funded in Australian dollars, while the underlying holdings we invest in are denominated in USD. As such, currency fluctuations can impact portfolio profits. Our hedging strategy sees us leveraging the portfolio to a falling Australian dollar – or increasing USD – which has proven to be a successful strategy over the last year or so.
There is opportunity cost by selling out of equities
By now you’re probably wondering if the intent of hedging is to mitigate losses, why not just sell all equities? However, this line of thinking ignores the fact that there are numerous advantages when utilising hedging instead of selling out of everything.
The first of those benefits relates to timing. And when it comes to timing, no one has the ability to pick the top and bottom of the stock market with any sort of reliability or in the absence of some good luck. This means, being even just slightly off when timing an exit can result in you leaving significant gains on the table, or your prediction of a downturn could turn out to be wrong. At the end of the day, timing is ultimately a risk that needs to be factored into each trading decision, whereas opting for a hedging strategy mitigates that risk and any fallout, plus gives peace of mind.
It’s also worth considering some of the behavioural traits that emerge in a ‘risk off’ market. When investors tend to exit a particular stock, or equities altogether, they then tend to sit on the sidelines for some time. If the stock recovers, or even races ahead of where it was, anchoring bias can come into play. That is, you may be inclined to wait for the stock to return to its momentary low, which may never happen. By then, your opportunity costs will be adding up quickly.
Holding onto your stocks also ensures that you retain maximum exposure to any individual news event that could be material to a company. Even in a broad-based market downturn, individual stocks can still outperform and chalk up gains. Often, this is because of sector-based strength, like gold stocks or defence companies. However, in other instances, a specific catalyst could emerge that underpins one company’s future growth.
Last but not least, let’s consider the broader picture of the stock market. There have been numerous ups and downs over the years, however, over the long-term the market continues to trend higher. Even when you consider some of the major corrections over the years, these are just a blip on the charts. Not to mention, this is without considering the benefits of dividends and compounding returns that would have accumulated while retaining your equities and instead managing risk through hedging instruments.