I’ve mentioned a few times over the past couple of months that I currently have the “Growth” allocation of client portfolios hedged against a drop in the stock market. In this post, I hope to explain what it means to be “hedged,” why it’s important to hedge risk, and how I’m currently doing so.
From Investopedia, the term “hedge” means:
A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security…
Hedging is analogous to taking out an insurance policy. If you own a home in a flood-prone area, you will want to protect that asset from the risk of flooding – to hedge it, in other words – by taking out flood insurance. There is a risk-reward tradeoff inherent in hedging; while it reduces potential risk, it also chips away at potential gains. Put simply, hedging isn’t free. In the case of the flood insurance policy, the monthly payments add up, and if the flood never comes, the policy holder receives no payout. Still, most people would choose to take that predictable, circumscribed loss rather than suddenly lose the roof over their head.
Hedged Funds were first started back in the 1940’s and ’50’s. Back in the day, they were a true “hedged fund” in the sense that they were invested and diversified, but they would hedge risk. Somewhere along the line we lost the “d” off the end and now they’re just called “hedge funds.” Very few of them actually hedge risk in the traditional sense. Instead, a hedge fund is now synonymous with a speculative, risk taking fund that focuses on some kind of special investment “style” like Long-Short, Risk Arbitrage, etc. The way we’re hedging is in the traditional sense – we’re invested with a long time horizon, we’re diversified, and we’re hedging (mitigating) risks as they pop up to minimize volatility in the short-term.
Here are some simple illustrations to help explain the purpose of hedging. In an ideal situation, I believe this is everyone’s goal when it comes to the stock market:
How great would it be if we could perfectly time the market, to ride the climb during the good years (shaded green), exit at the top, avoid the bad years (shaded red) and re-enter at the bottom. Our portfolio would look like a staircase over time: climb…flat…climb…flat…climb. Hopefully everyone understands that this isn’t realistic because timing the stock market to this degree is near impossible since the market is never rational and often driven by emotion to great extremes. Plus, this is trading, not investing.
In reality, the next best thing is to minimize the drawdowns during the bad years by managing risk (i.e. hedging). Here’s how it would look over the long haul if done properly:
It’s still very possible to experience drawdowns during the bad years (and likely that you will). The goal is to lose as little as possible and far less than “the market.” But notice that if you’re investing with a long time horizon you don’t even have to fully participate during the good years (i.e. you can underperform) because by managing risk during the bad years, you’re not climbing out of such a large hole. The end result is that you outperform in the long-term while experiencing lower volatility and creating a smoother path higher. For all math nerds out there like me, the lower volatility/avoidance of big losses is, mathematically speaking, the reason you create a higher geometric average annual rate of return. It’s your risk management during the bad years that determines your long-term performance. Wealth isn’t built by hitting homeruns; it’s built through stable returns by avoiding large losses when the odds are stacked against you.
How We’re Hedged
2015 was a relatively flat year for US stocks. Most stocks were down but the major averages, like the S&P 500 Index, finished the year relatively flat, held up by a small handful of the largest companies. Because of this, I don’t expect 2016 to be flat. The forces that have been pushing stocks higher are still in effect, albeit waning, so I can see the potential that the market climbs another 10%+ this year. At the same time, economic and market data is starting to say that things are deteriorating so I can also see the potential for a sizable drop in the market. Therefore, I have taken the stance that the best way to position portfolios over the next year is to remain invested but to hedge the risk of a large drop. I’ve basically positioned portfolios to benefit from a big move in either direction.
Other than traditional investments like US Treasury bonds, the best way to directly hedge the risk of falling stock prices is typically to use options since you can limit your risk but still participate to the upside. Purchasing put options is like purchasing “stock insurance.” Like all types of insurance, you have to pay a premium to buy the protection. If you don’t use the insurance, your premium is lost. There are other ways to use options to hedge stocks, like selling call options, but buying put options is the most direct way to protect against substantial losses.
Here’s a hypothetical example for illustrative purposes only to demonstrate how put options work (this excludes taxes and trading costs to keep it simple). If you’re new to options, don’t get caught up with the math right here. Finish the whole post and then come back to this section and it should make a lot more sense.
- You have a $400,000 portfolio
- Half ($200,000) is in stocks and the other half is in bonds
- The S&P 500 Index is a fairly good representation of your stock exposure and the index starts the year at a price of 2040. You can basically think of this like you’re investing $200,000 in the S&P 500 at 2040.
- You’re concerned that your stocks might drop a lot over the next year so you look at purchasing “insurance” via a put option. An investor has the ability to select any price at which their insurance will kick in, but the more protection you want, the more expensive it will be. You decide to purchase 1 put option on the S&P 500 that protects you over the next year if the index falls below a price of 2000 (roughly 2% below the current price of 2040). Each option represents exposure of 100 shares, so you have insured your full $200,000 worth of stock exposure (100 shares x price of 2,000 = $200,000).
- This insurance will cost you a premium of $10,000 (5% of your $200,000 invested in stocks (2.5% of your total $400,000 portfolio)). So, the most you could lose from your stocks over the next year is roughly 7% (a 2% drop from the current price of 2040 to the level of insurance at 2000 + another 5% for the cost of insurance). You can see that put options can be expensive which means they’re not something you should be buying each and every year…only when you think there’s a high likelihood of a big drop.
Potential outcomes over the next year:
- If the S&P 500 rises by 20% over the next year, your stocks go up 20% ($40,000) but you paid $10,000 for the put option premium, so your net gain is $30,000. Still a solid return.
- If the S&P 500 rises by 10% over the next year, your stocks go up 10% ($20,000) but you paid $10,000 for the put option premium, so your net gain is $10,000. Not stellar but still good to make money and you were able to sleep easy the whole year.
- If the S&P 500 falls 10% over the next year, your stocks lose 7%
- If the S&P 500 falls 20% over the next year, your stocks lose 7%
- If the S&P 500 falls 30% over the next year, your stocks lose 7%… you get the picture
- There’s also a strong chance that the bonds in the other half of your portfolio will make money, improving your total return.
I picked the numbers in the above example for a reason. The S&P 500 Index started the year at roughly 2043 and we (i.e. my clients) currently own put options on the S&P 500 that kick in at a price of 2000. Now, we invest in the stock of individual companies, not the S&P 500 as a whole, so put options on the S&P 500 does not truly cap our risk but theoretically we’re hedged pretty well. It’s just more cost-effective to buy 1 option on the S&P 500 than individual put options on each of our stocks. The hope is that our basket of stocks actually outperforms the S&P 500 which could provide an extra kick on top of the hedge. But since our losses are basically capped, theoretically speaking, this is why it would be OK if the stock market fell a lot this year. If our loss is the same whether “the market” falls 10%, 20%, 30% or more, the more the market drops, the better the price at which we can buy in later this year (i.e. lower) to then ride the next move higher.
This puts us in a position of flexibility and makes us indifferent to the direction of the market this year. It’s just a question of today vs. tomorrow, with “today” meaning the next year or so and “tomorrow” meaning the years after. If the market goes up, we’ll make money “today.” If it goes down, our losses will be limited “today” and we’ll be able to buy in at much lower prices to make money “tomorrow.” Either way, we’re in a position to do well in the long run.
Thanks for following!
Nick
Please note: the max loss of 7% in the example above is for illustrative purposes. Because every portfolio is invested differently, it will require a different amount of insurance. The more aggressively a portfolio is invested (i.e. more exposure to stocks), the more insurance it would need.