Prospect of volatility points to need for hedging

In today’s yield-compressed world, investors globally need to face up to a precarious quandary: how to generate attractive returns without exposing themselves to excessive risk.

The answer in recent times has been to invest in equities to counteract low bond yields, safe in the knowledge that they could rely on extreme monetary and fiscal policies to dampen market volatility.

The global economic recovery from the Covid-19 pandemic delivered an added motivation to invest in equities. It has provided ballast to company earnings, driving stock markets to fresh highs. The MSCI All Country World Index near doubled from March 2020 to September 19 this year, rising 82%.1

However, the impact of prolonged extreme policy settings on markets is difficult to predict, and we see reasons for investors to consider future-proofing their portfolios against a return of volatility and large swings in asset prices.

At the least, they need to contemplate a time when the impact of fiscal stimuli will start to fade. Further, the re-emergence of inflationary pressure shortens the horizon for rate rises. This comes amid a tense geopolitical backdrop as the US and China strive to disentangle their financial markets.

We see the fragility of investor portfolios with heavy allocations to high-flying equities but little downside protection.

It underscores the potential fragility of investor portfolios as we look ahead, most notably those with heavy allocations to high-flying equities but little in the way of downside protection.

Evidently, investors can’t rely on bond holdings to deliver the same level of capital appreciation and income they have in the past. In a nutshell, bonds won’t compensate for equity losses in future.

What investors don’t want is to be tied up in assets offering little or no return potential but that still carry significant risk from rising interest rates and inflation.

Given extreme policy settings and high asset valuations, there’s plenty of scope for market corrections. Although volatility isn’t a reason to exit markets in itself, we do think investors need to become mindful about managing their downside risk.

With a wider range of hedging tools available than ever before, now is a good time to look for hedges with the right structure at the right price to add value to portfolios.

We recommend investors allocate to hedging strategies that are negatively correlated to the rest of their portfolio. There are strategies that can reduce capital losses from large drawdowns (peak to trough declines), provide access to liquidity during dislocations and improve compound returns.

Certainly, investors can choose to ride out volatility over the long term. However, drawdowns can have a resounding impact on compound returns.

For example, if you invest $100 and there’s a 50% fall in the market, you are left with $50. But you will need your money to increase 100% (or double) just to get back to where you started.

There’s no single hedging strategy that will protect portfolios through the entirety of a sell-off, and allocating to various strategies – such as put and collar options – is typically expensive and can offer limited liquidity and transparency of underlying holdings.

Moreover, while some hedging strategies lower portfolio volatility and reduce drawdowns, they can limit long-term returns. But actively managing a diversified set of defensive strategies can help both to protect portfolios and reduce the cost of protection.

Certain strategies offer daily liquidity, enabling investors to monetise gains quickly and reallocate capital during times of stress. Importantly, they also allow investors to maintain their exposure to the higher return potential of equities during more benign market environments.

This can help to avoid selling assets at distressed prices, help to lock in gains and generate cash to enable investors to buy under-priced assets following a market fall. Rebalancing during volatility – buying low and selling high – can provide a strong positive dollar contribution to portfolios.

Ultimately, we believe regularly allocating to a hedging strategy negatively correlated to the rest of a portfolio will help investors to manage a path that we expect to become more volatile amid highly unusual times.

People worldwide buy insurance to protect their domestic assets. By the same measure, we think it’s prudent for investors to buy insurance for financial assets. After all, you never know when you might need it.

1 Bloomberg, September 19

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