3 Traits your hedge needs in volatile markets - J.P. Morgan Asset Management

3 Traits your hedge needs in volatile markets

Contributor Hamilton Reiner

Since the market bottom in March 2009, stocks have risen a little over 200% and volatility has been relatively muted. But looking ahead, we expect equity returns to moderate and volatility levels to rise. As a result, investors may want to think about hedging strategies to mitigate their downside risks, maintain their equity allocations in a risk-controlled way and bounce back from downturns more quickly. We believe that investors need to consider the following three traits in their hedging strategies:

Your hedge needs to work—not some, or most, of the time—but all of the time.

A key assumption behind diversifying across asset classes is that correlations remain constant over any one investment horizon. The idea is that over a long period of time, stocks and bonds won’t move up or down at the same time, or at least by the same degree, which can smooth out returns, hedge portfolios against big losses on single investments and position investors to benefit if one corner of the market posts outsized gains.

But depending on market and volatility regimes, correlations can vary. Exhibit 1 shows the relationship between fixed income and equities and the correlation between the two. Since January 2004, the average correlation between the is -0.09, but it has ranged between a minimum of -0.61 and a maximum of 0.64.

Recent correlations between stocks and bonds have become more positive

Exhibit 1

Diversifying within the same asset class through the use of equity hedges, however, can reduce investor’s dependence on correlation levels and dampen volatility in a more systematic, controlled and cost-effective manner. This is likely to result in returns that are slightly more certain and predictable than returns from traditional asset allocation.

Hedging strategies should help investors recover from losses more quickly and stay invested during volatile periods.

A key advantage of a hedging strategy is that it protects capital during market troughs so investors have less ground to make up. This relationship becomes more pronounced with larger losses because the gain required to get back to even increases at a faster rate. A 40% portfolio loss, for example, will require a 67% gain to get back to breakeven.

In addition, by smoothing out the ride during periods of market volatility, the strategy helps investors stay invested—instead of panicking and selling out at a market bottom. Exhibit 2 shows the powerful effects of portfolio diversification by illustrating the difference in movements between the S&P 500, a 60% equity/40% bond portfolio and a 40% equity/60% bond portfolio, and how long it took each respective portfolio to recover from its losses in 2009. It shows that the pure equity portfolio fell far more than either of the two diversified portfolios and also took two or more years longer to recover its value.

Minimizing the impact of volatility helps investors get back to breakeven more quickly

Exhibit 2
Don’t try to time your hedges.

Left to one’s own devices, the average investor only narrowly beats the rate of inflation. Exhibit 3 compares the 20-year annualized returns across asset class with the returns an average investor would have experienced. The reason behind the sharp gap in returns is that the average investor tends to make emotionally charged decisions—such as buying high and selling low. Investors who stay invested for the long term are consistently more successful than those who try to time the markets. Since it is difficult, if not impossible, to time one’s hedges, incorporating equity hedges as part of the portfolio’s construction can lead to consistently more successful results than market timing.

The average investor just barely beats the rate of inflation

Exhibit 3. 20-year annualized returns by asset class (1995-2014)

Exhibit 3
Investment implications

As we enter an environment of lower returns and higher volatility, investors should consider hedging strategies that can help reduce volatility in a more disciplined manner, recover from losses more quickly and dampen volatility in a more systematic, controlled and cost-effective manner.

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