There’s an old trading floor saying “if you want to hedge, grow a garden.”
Seems a bit dismissive of an approach that can ease anxiety in even the most turbulent of markets.
In such trading environments, hedges quite effectively serve as a diversifying asset, or something that goes up when what you’re worried about goes down.
For example, if the potential for a falling equity market has you stressed, you should probably have a hedge on your equity market exposure. That doesn’t mean pulling your money out of the market, but using a financial instrument designed to buffer the downside possibilities—at least enough that you’re not constantly making decisions about whether you should liquidate or not.
Ultimately, a truly effective hedge will keep investors from falling as far as the market in down times. Admittedly, it will likely limit gains during rallies, but the tradeoff provides some peace of mind to investors who want to stay invested but get queasy about riding out market lows.
Traditional Thinking Has Its Gaps
For decades, investors have looked to other types of investments that may respond differently to market conditions to try and offset equity market losses.
Some of the primary asset classes traditionally used as a counter include:
Bonds—Fixed income investments tend to offer more stable valuations than stocks, partly because they’re aided by yields that go up as values go down (and vice versa).
Cash—Tied to the shortest-term bonds in the market (with yields that hew closely to the U.S. Federal Reserve’s key interest rate), cash investments are usually designed to not lose principal value while collecting modest interest.
Gold—The flagship of the commodity world, the yellow metal is commonly viewed as a safe haven when financial and geopolitical crises erupt.
Run the numbers and you’ll see that all of these may have exhibited hedge-like behaviors for stock exposure at times.
But they don’t always work. They rely on statistical measures, which don’t offer mathematical certainty.
Need proof?
In 2022, when the S&P 500 Index fell nearly 20%, the Morningstar U.S. Core Bond Index, which is comprised of government and investment grade corporate bonds, lost about 13%. Gold posted a fractional gain, but only because the U.S. dollar weakened in December of that year—a development completely disassociated from the equity markets.
Similarly, money market accounts, where many cash investments are held, reversed a decade of dismal returns by tracking the moves of the Fed, which increased its key lending rate by 4.25% during the year.
Sure, the traditional hedges offered mixed returns, but their moves were rooted in their asset class dynamics, not in opposition to the stock market. Plus, staying too long in another asset class may have cut sharply into a portfolio’s 2023 stock market returns, when the S&P 500 Index jumped nearly 25%.
Even the Investing Industry Fallback Faltered in 2022
Another strategy that many consider a market hedge is the 60/40 portfolio, which is rooted in the logic that holding 60% of your portfolio in equities and 40% in bonds will level out returns because the two asset classes are not highly correlated. According to Vanguard, such a mix generated a 7.5% annual return between 1926-2022, and only lost ground in 19 of those 97 years.
One of those down years was 2022, when declining bonds failed to mute the volatility in a plummeting equity market. While the S&P 500 Index fell 20%, the Bloomberg US Treasury Index retreated 12.5%, and the average 60/40 portfolio dropped 16%, according to Vanguard.
Digging deeper, corporate bonds declined some 20%, and that takes a long time to battle back in a marketplace where it’s supposed to be a much more lower volatility environment than we see in equities.
So, yes, in the past, the 60/40 has worked to smooth out portfolio returns. At times.
But not because it’s built with two asset classes that move in opposite directions. Exhibit 1:
2022, when it went badly.
As for That Bright, Shiny, Blockchain-Based Object...
In January 2022, many investors thought that because interest rates were so low, there was considerable risk that they would rise, so non-fixed income strategies grew in popularity among market hedgers.
One of the flashiest was cryptocurrencies, which seemed poised to be the latest and greatest negatively correlated hedge. With no ties to either the equity or fixed income markets, these investments were purported to be the truest anti-market investment available.
Oh, but they weren’t.
Bitcoin price, 2019-2024
Source: CoinCodex
Cryptocurrencies dropped more than 50% in 2022, screaming past most mainstream markets to the downside.
And yes, in 2023, they staged a comeback, but so did the equity markets.
Again, a diversifying asset goes up if what you’re intending to hedge against goes down. While distinct from the world of traditional investments, cryptocurrencies have consistently failed to meet that bill.
When Hedging Strategies Go Off the Rails
Market doomsayers like to invoke the concept of tail risk when recommending market hedging strategies.
Technically, tail risk kicks in when an investment ventures more than three standard deviations from its mean, or that miniscule strip of possibilities far from the center of the typical bell curve of normal distribution.
To effectively guard against tail risk, an investor must assume a sophisticated position that we liken to a bunker that you build underground for Armageddon. So, when the world ends and you have this tail risk hedge, it’s going to deliver to whatever happens after Armageddon.
Lately, debates over tail risk have hinged on differently shaped distribution curves with seemingly thicker tails indicating a higher possibility that extreme conditions will arise.
Source: Pimco
Regardless of the breadth or depth of the tail in question, our concern with hedging against tail risk is that it’s not going to come in handy when the equity markets are down 10%, 15%, or 20%. Those unsettling types of drops will—and do—occasionally happen, so how is your portfolio protected from those setbacks?
A Quick Aside on Timing Strategies
Occasionally, a manager promotes the view that in following their proprietary methodology, they will effectively protect investors from downturns by moving them out of the market.
That absolutely protects if you nail the perfect spot to get out. And the perfect spot to get back in.
Miss by a day or two in either direction, and the underperformance snowballs, as J.P. Morgan found through just the first 11 months of 2023.
Source: J.P. Morgan Private Bank
Even if such results weren’t so dramatic, we’re not in the business of timing market moves. And we believe most clients are not into market timing, either.
They generally want to keep invested.
We know a real fear factor can kick in when the downdrafts are strong and it feels like it might be time to get out. Which, of course, is the worst time to exit the market.
We view our approach as guardrails to investors to remain in the market because that’s one overarching key to investing success: Staying invested for the long term.
Everybody knows the Warren Buffett quote along the lines of he’s a buyer when everybody else is selling and he’s a seller when everybody else is buying. We’re not going to do that because we’re not market timers, but we will do our best to make sure you’re not that person selling to Warren Buffett at the market lows.
What Can Be an Effective Market Hedge?
When investors accept that the hedge-like assets such as cash, gold, bonds, 60/40 portfolios, and cryptocurrencies don’t truly act in opposition to the equity markets, what’s left?
Truly, the purest negatively correlated tools are options. Derivatives that represent bets on the direction of the market.
We know derivatives can be scary. Especially given the considerable role they played in the Global Financial Crisis.
Plus, options-based strategies can also be costly due to an abundance of high trading costs.
Where we believe investors can best benefit from derivatives is from a highly transparent active management approach that is periodically adjusted to the market realities while remaining:
- Systemic
- Disciplined
- Not over-traded
To the latter, we make our trades on a monthly basis and stick to the structure that we discuss with investors when they first sign on with us.
We know derivatives contributed to some of the biggest blowups on Wall Street—we were right there alongside you. But the situations were exacerbated by the opaque nature of the trades, the strategies being used, and an over-reliance on leverage, which tends to magnify moves exponentially.
Here’s a sanity check:
If a manager can’t explain what they’re doing in 3-5 sentences, consider ending the conversation. When it goes beyond that, then it’s usually very difficult for an RIA to explain it to his or her clients. And that might not be the best place to hedge your equity exposure.
Alternatively, we oftentimes tell our clients that if they see us doing anything outside of the parameters that we have established, they should fire us. We don’t give ourselves leeway to stray—we stick to the plan that we lay out for our investors.
That said, we often advise people to pick the hedging manager and strategy that uses the derivatives you’re most comfortable with. Just like most RIAs or advisors would tell people to pick the mid cap manager or corporate bond manager they’re most comfortable with.
The Proof in Our Pudding
We addressed how true tail risk hedges are targeting post-Armageddon returns. We, however, focus on more likely setbacks.
More like when a really bad snowstorm is barreling down on your city, you know you’re going to lose power for three, four, or five days, and you need to get through it.
We buffer the downside of equity market returns by hedging your equity market exposure.
We’ll get you through the snowstorm for five days so you’re not forced to burn the furniture in the house to keep the heat on.
If the market is down 10%, we’ll likely be down 4%-6%. And since we want to capture less of the downside, we do miss some of the upside, so with the market up 10%, we’re shooting for a 6%-7% return, helping you achieve a constant exposure to the marketplace.
Our strategies don’t rely on the dynamics of another asset class because ultimately, we believe that if you’re looking to hedge your equity exposure, hedge your equity exposure.
