Given the highly uncertain economic and geopolitical outlook, investors are increasingly looking for ways to hedge equity risk in portfolios. Investors and their advisors should spend time to compare and fully understand the wide variety of hedged equity funds in the marketplace, as they can have dramatically different outcomes in different scenarios depending on the approach taken.
While most approaches provide protection in down markets, many significantly lag the equity markets over the long term, providing a disappointing experience for investors. Our view is that equity investors should be willing to withstand occasional market corrections of around 10%, as they are a normal part of healthy market behavior. Investors should be more focused on the risk of permanent impairment of capital that could come with a major bear market. These significant market drawdowns not only reduce wealth, but can also cause an emotional reaction that could lead investors to cut equity exposure when they should be adding to it. We think a hedged equity strategy that has the following attributes (such as the Overlay Shares Hedged Large Cap Equity Strategy) can provide an optimal balance of downside protection and upside participation, allowing investors to hold it as a core long term part of their asset allocation:
Low-Cost, Passive Exposure to the S&P 500 Index
Given the high level of difficulty for managers to beat the market through stock picking in large cap equities over the long term, we prefer cheap, passive beta exposure through low-cost ETFs.
Long Term Bear Market Hedges
The portfolio hedge is typically done through the purchase on downside put options on the S&P 500 Index that provides a protective floor at a certain level (strike price) for a specified period of time (up to the expiration date). Downside hedges lose their time value more quickly as their expiration date approaches. As such, the long-term cost of constantly purchasing monthly or quarterly hedges can be significantly more expensive than purchasing hedges that are a year or more out. Furthermore, these long-term put options can be monetized months before expiration to recoup a portion of initial cost. It is also important to strike a balance between cost and protection by focusing on hedges that will protect against bear market declines as opposed to standard market corrections.
Hedges that are Laddered Over Time
In order to reduce the path dependency of the hedges, it is important to have multiple strike prices and expiration dates. Laddering the hedges with expiration dates spread out on a monthly or quarterly basis can help to further smooth out returns.
A Protective Floor that Dynamically Moves with the Market
Many hedged equity strategies simply hold purchased put options to expiration. In doing so, they are 1) unable to monetize profitable hedges during moments of peak volatility and 2) vulnerable to an “air pocket” if the market rallies significantly higher than the floor. An optimal approach is to have a process for dynamically moving the hedges up and down to take advantage of or to protect against market changes.
Avoid Using Covered Calls to Finance Hedges
While covered call writing makes sense in certain situations, over the long term the appreciation lost from covered call writing (“opportunity cost”) can far outweigh the premiums that are collected. During sharp market rallies, covered calls can cause investors to miss out on a significant amount of portfolio appreciation. In the context of a hedged equity strategy, this lost appreciation in rising markets can more than offset any benefits received from the downside protection. There are ways to help to finance the hedges that does not cap the upside of the equity portfolio, allowing investors to benefit from more equity-like returns over the long term.
We routinely work with advisors to determine the proper approach based on the needs of their clients. We welcome the opportunity to serve as a resource for what can be a confusing fund space.
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The assertions and statements in this blog post are based on the opinions of the author and Liquid Strategies. The examples cited in this paper are based on hypothetical situations and should only be considered as examples of potential trading strategies. They do not take into consideration the impact that certain economic or market factors have on the decision making process. Past performance is no indication of future results. Inherent in any investment is the potential for loss. Options involve risk and are not suitable for all investors. Please see the following options disclosure document (ODD) for more information on the characteristics and risks of exchange traded options.
