It’s Better to Be Smart Than to Sound Smart
Ask A CIO #61
I don’t think this has turned out to be the week that any of us expected. For investors, this week is the latest reminder that market conditions can change rapidly. There are a lot of smart folks sharing smart thoughts, but what does anyone really know about what happens next? Wars don’t tend to have predictable, tidy resolutions.
For individual investors, whose portfolios are often highly liquid, there may be a temptation to react to all the headlines. Should you reduce equity exposure? Increase energy holdings? Move to cash and wait until clear skies ahead? (Spoiler alert: it could be a long wait.)
For institutional investors, any temptation to react would be likely irrelevant. As I’ve noted before, the typical institutional investor’s size, complexity, and liquidity constraints make it highly difficult to quickly shift portfolio exposures in any big way. And perhaps counterintuitively, that’s very much a positive, structural advantage. It forces long-term decision making.
Compared to individual investors, institutional investors in aggregate also came into this week with more broadly diversified portfolios, which means more variation in the sources of potential returns, and ultimately, more resilient portfolios. So while I would never encourage individual investors to make reactive portfolio changes, I do think this is as good a time as any for investors to be extra thoughtful around diversification and their long-term asset allocation targets.
On to this week’s question:
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What do you think about portfolio hedging, with equities at all time highs?
Obviously, this question came in during an earlier week. But even though markets are no longer at all-time highs, I still think it raises relevant concerns. For investors worried about downside risk in markets, that instinct to protect the portfolio is probably as strong as ever.
That said, in my experience, portfolio hedging rarely makes sense. I’ll caveat my answer here by noting that while I have seen a lot of different hedging approaches across various fund managers, I am admittedly not an expert in portfolio hedging. In fact, most institutional investors I know (and I’m willing to bet it also applies to a lot of those I don’t know) do not run tail risk hedging programs.1
Let me also clarify that for this conversation, I’m defining portfolio hedges as financial instruments used specifically to reduce some risk or other. In this context, hedges would include things like put options on equity indices or interest rate swaps. On the other hand, I generally wouldn’t consider an investment in gold to be a hedging instrument.
For most investors, maintaining a disciplined, diversified portfolio is the most effective risk management strategy. Large institutional investors think a lot about asset allocation and the equity risk within their portfolios. As I’ve discussed before, these investors build multi-asset class portfolios with deliberate allocations to equity investments and non-equity investments. The non-equity parts of the portfolio are 1) expected to generate returns that don’t correlate to the equity parts of the portfolio, and 2) help protect the portfolio when equity markets experience drawdowns.
Assuming an investor is maintaining their equity exposure within their targeted range, that investor is already mitigating the potential impact from a significant equity market decline. Diversification inherently serves to protect portfolios.
Next, let’s consider the cost of hedging. As an individual investor, you won’t have access to all the hedging tools that institutional investors might use, so you’re already starting from a more limited position. Like, nobody is going execute a credit default swap with you.
What might you use instead? Put options are probably among the more easily accessible hedging instruments. But there’s a cost to buying options, and those premiums can really add up. Let’s consider two of the key components to pricing option premiums: time value and volatility. Unless you’re making a market timing call and certain you know when markets will decline, you’re probably not looking at put options with near term expirations. You’re probably considering put options that expire further out in time, which means you’ll have to pay up a bit more for that time value.
Let’s say you get the timing right, and your put options are in the money before expiration. Now what? Do you continue protecting the portfolio? If your equity put options are in the money, it’s because stocks declined, and the likelihood is that volatility has increased. So now the option premium on new puts is higher. How much additional cost do you want to take on? After all, these premiums are real dollar costs that will eat into the value of your overall portfolio.
And I recognize not everyone will agree with me on this, but there can be a huge mental cost to managing portfolio hedges. There’s a lot of complexity associated with structuring and maintaining portfolio hedges. Unless you’re highly experienced, even if you have access to all the same choices as an institutional investor, those hedges are still likely to lead to some real brain damage.2 I think hedging often sounds smarter in theory than it actually is in practice.
When I think about all the hedging programs I’ve seen across fund managers over the years, the most successful ones, at a minimum, had:
A clear understanding of the specific risks they were looking to hedge;
Dedicated traders thinking deeply and often creatively about the lowest cost way to construct those hedges;
The ability to look for hedging instruments across asset classes and geographies; and
The ability to dynamically shift hedges in the portfolio.
Hedging can absolutely make sense for investors looking to isolate out a specific risk that they want to take from broader risks that they don’t want to take. Think, for instance, a U.S. investor that wants to invest in a Japanese stock but doesn’t want to take on currency risk. These are often discrete hedges, for a discrete purpose, over a discrete period of time.
Running a proper hedging program demands a fair amount of attention, dedication, and expertise. If you’re feeling uncomfortable with equity valuations, maybe don’t jump to layering on expensive portfolio hedges. Instead, consider revisiting your asset allocation. Institutions build multi-asset class, diversified portfolios to withstand periods of equity volatility. And I would say that broadly, this approach is more sustainable (and involves a lot less brain damage) than trying to time the market or run a tactical hedging program.
Thanks for joining, and as always, reach out with questions: askacio@ivyinvest.co!
See you in two weeks,
Wendy
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Tail risk generally refers to low probability, high impact risks. A week ago, investors might have considered war in Iran a tail risk, but here we are.
Negotiating an ISDA is not a trifling thing, and now you’re assuming counterparty risk. Again, just so much brain damage.