Hedging…Revisited

October 22, 2020

It has often been said that the market “climbs a wall of worry.” And arguably, there is a lot for US investors to worry about these days. Coronavirus cases are on the rise again, the economy is still struggling to emerge from recession, government stimulus talks have stalled, and the presidential election is in less than two weeks. Yet, in the face of these worries, the stock market continues to climb, causing concern that the rally that began in late-March is not sustainable and that stocks are ripe for a fall.

A few months ago, we wrote to you with thoughts about hedging – actions that one could take to mitigate risk in your portfolio. We thought it would be a good time to revisit the topic as the market continues to rise.

Maybe I should just sell equities, go to cash, and wait until after the election?

In a previous Wealth Watch, we discussed the perils of letting our political persuasions affect our investment strategy. This notion was reinforced further in the Votes and Volatility event – an interview with Dimensional’s Dr. Apollo Lupescu. For those of you who were unable to attend, we just sent out the recording of the event and encourage you to listen.

In general, we know that timing the market (i.e., going to cash) is a fool’s errand. Markets can drop quickly and rebound just as quickly. We need not go back further than this spring to see evidence of how the urge to time the market would have been disastrous for one’s portfolio performance.

That said, having some cash on hand is never a bad thing. You should keep enough cash in the bank to cover near-term expenses and provide a level of comfort/security. However, holding cash strategically as an investment in an environment with zero short-term interest rates and a Federal Reserve poised to keep interest rates low for several years is challenging. Cash has no meaningful yield and won’t for some time.

What about buying insurance on my portfolio such as options?

Another way to mitigate downside risk is through put options. A put option gives the holder the “option” to sell a security at a pre-determined level called the strike price. One could even buy a put option on an index like the S&P 500. While this may sound attractive in theory, in practice put options are a very expensive form of portfolio insurance. For instance, when the market was in freefall in March, buying a put on the S&P 500 would have cost over 12%. So, if one was trying to hedge $1 million of S&P 500 exposure, it would have cost $120,000 upfront! Now that same amount of insurance costs a little more than 5%. While certainly less expensive, it is still a lot of cash out of pocket.

The thing about portfolio insurance is when you’d most like to have it, it can be prohibitively expensive to implement. And all options have a finite life meaning they do expire at some point. And if an option expires without you having exercised it, you then must decide whether to renew the option/insurance, requiring additional cash out of pocket. Furthermore, put options don’t eliminate your downside – they only reduce it. You must be willing to absorb some drop in value before the option kicks in and the less downside you’re willing to absorb, the more expensive the option strategy is to implement. And while there are more complex option strategies than just buying put options, that additional complexity comes with a lot more risk.

Bonds offset the risk of stocks, but will they offer any sort of return in a low-interest rate environment?

Yes – it’s true that bonds offer the best pure protection against the downside of stocks. And, despite what one might think, even in a low-interest rate environment, bonds can provide decent returns. For one, not all bonds are the same. Different areas of the bond market perform differently so diversification does matter. It’s also important to use managers that are nimble and that actively shift their holdings to capture opportunities as they arise. And, with the Fed committed to providing liquidity for the market through quantitative easing (buying Treasuries, corporate bonds, etc.), there may continue to be demand for bonds that drive up prices and returns even if interest rates remain low.

Conclusion

While there is no magic bullet when it comes to protecting your portfolio against downside risk, simple is better. While timing the market and employing more complicated forms of portfolio insurance can seem appealing, they come with high costs and no guarantees. In the end, making sure you have a stock/bond allocation that not only helps you meet your planning goals but also is consistent with your tolerance for risk continues to be the most effective way to grow your wealth and to manage risk.