Too Much Too Soon? Time to Hedge?
Eight weeks ago, the markets were in the pit of despair. Even Treasury bonds were trading with abnormalities. Since then, an incredible surge has happened. Yet the speed and magnitude of the recovery has led many to question the rally. After all, the bad news isn’t done yet (which we have touched on in recent Wealth Watches).
Though no one knows for sure which direction the markets go in the short-term, you may be fearing a return to negativity. To address that worry, here are a few strategies you could undertake to protect against the downside.
You should always have some cash on hand. In times like these when volatility and uncertainty is especially high, cash feels really good. But should you have more? One thing we know for sure is that cash is not paying anything and likely won’t for a while. The Fed has acted aggressively to help spare the economy, and a casualty to this effort has been any type of yield on cash. So, keep enough cash to cover some shorter-term expenses and security, but beyond that, cash may eventually wear on you.
If you’re worried about a market downturn, you can buy insurance against this, also known as a put option. This type of option gives you the right to sell a security at a pre-determined price. So, if the market falls, you can still sell at the pre-determined, higher price. As of 5/18/20, buying an ‘at the money’ put on the S&P 500 to expire 10/16/20 (5 months later) carried a cost of 6.87%, or $68,700 for every $1,000,000 of stock. If you wanted to save yourself a little money and can sustain some loss, say -5%, you could do an ‘out of the money’ put. Now the cost of protection is 5.4%, or $54,000 on every $1,000,000 of stock.
What needs to happen for this to help you? The market must drop by about -10.4% for you to “win.” If the market doesn’t fall that much between now and October 16th, you are simply out $54k and must choose to buy another put or not. If you don’t and markets go down on October 17th, you’re out of luck having been right about a downturn but wrong about the timing. Hedge for the entire year instead? Now the cost is almost $130k.
Options can have many useful cases, but long-term hedging against the downside has its challenges. They carry a cost and expire, and the cost they carry unfortunately goes up when volatility is high, when it feels like you need it the most.
This solution is not perfect, but it does provide plenty of advantages for long-term investors. First, diversification takes out the need to be right on timing. We don’t know which part of the portfolio will do the best in the short-term, but we don’t need to. With diversification, we know there are some elements in there that will do well the next year and some that won’t.
If we look at stocks and bonds as diversification for each other, we have seen that hold up in 2020. While bonds have not been unaffected, when we look on the year, they have been positive despite stocks still being down (see chart below). We also know that versus the other two options above, bonds are still providing an income in the form of interest. Yes, this has come down a good chunk when we just look at Treasury bonds, but other high-quality areas of the bond market, like investment-grade corporate and municipal bonds, continue to provide relatively attractive yields. You get paid to take risk off the table in this case vs. cash (no interest) and options (cost).
Source: YCharts year-to-date 5/15/2020
There is no silver bullet to protecting a portfolio because timing is never predictable. It’s as important now as ever to make sure you have the right allocation and cash buffer ahead of a potential slip back down in the markets. By proactively maintaining a diversified portfolio on top of an appropriate cash cushion, you end up with a portfolio that can get you through whatever comes your way for the rest of 2020.
Source for option costs: http://www.cboe.com/delayedquote/quote-table?ticker=SPX as of 5/18/2020 at 11:37AM CDT
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The S&P 500 Index includes a representative sample of the largest 500 companies in the U.S.
The MSCI® ACWI (All Country World Index) Net Index measures global equity performance. It comprises of equities from 23 developed markets countries and 24 emerging markets countries measured in U.S. dollars.
Barclays Capital Municipal Bond 1-5 Year Blend (1-6 Maturity) Index is a sub-index of the Barclays Capital Municipal Bond Index, it is a rules-based, market-value-weighted index of one- to six-year maturities engineered for the tax-exempt bond market.
The Bloomberg Barclays Capital U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar-denominated. The index covers the U.S. investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
Chad spends his day helping BDF deliver on its promise of helping you enjoy a full life. In addition, Chad leads BDF's Investment Committee, which oversees the strategic and tactical decisions for the firm’s entire client portfolio base. Chad is a frequent speaker and is often quoted in publications such as The Wall Street Journal, Forbes, Investment News, Smart Money, ETF Perspectives, and Dow Jones Newswires.