Equity strategies that employ hedging can make sense as part of a long-term strategic asset allocation plan. Since these actively managed hedges aim to provide higher risk-adjusted returns over long-only strategies, investors can use them to meet a variety of investment objectives, from de-risking and re-risking to serving as a liquid alternative to hedge funds.
There are several equity hedging strategies—long/short, options overlays and covered call writing—that aim to reduce portfolio risk through shorting and options. Determining the appropriate strategy depends on the investor’s strategic objectives, risk profile and desired beta exposure.
In the context of traditional asset allocation, investors can reduce risk by diversifying across and within asset classes, assuming that historical correlations will hold in the future. Equity hedges are designed to reduce volatility in a more systematic, controlled manner, resulting in returns that are slightly more certain and predictable than returns from a traditionally diversified portfolio.
Successful equity hedging strategies start with an effective stock valuation and investment process. In addition, the complexities of managing options and short positions also require a set of unique and robust operational capabilities, as well as a portfolio team with the skills and experience in shorting and managing derivatives- and options-based strategies.
If investors have learned anything from the markets in recent years, it is that unexpected threats and volatility can quickly erase their hard-won equity gains.
Other than hiding out in cash, there is no easy way for investors to protect their portfolios from every conceivable danger. As a result, some investors are moving to managers who, through the use of shorting and options, are able to reduce portfolio risk without sacrificing significant equity exposure. This paper provides a broad overview of these equity hedging strategies and insight on what to consider when evaluating different types of equity hedges, as well as an examination of the roles these strategies can play in asset allocation and investor portfolios.
Too much beta, or not enough?
Since the market lows of March 2009, the S&P 500 Index has gained 173% through December 31, 2013. During that time, investors have experienced some of the sharpest swings in global equity market history. Although volatility and correlations among stocks have recently declined—providing a boon to fundamental stock picking—many investors, recalling the pain of the last downturn, are still sitting in cash and are only slowly increasing their equity allocations.
Other investors, however, are looking to decrease their equity exposure. With the equity markets’ gains in 2013 and the rise in interest rates, the funded status of pension plans of U.S. public companies has improved, prompting many corporations to consider de-risking strategies.(1)
Regardless of whether investors have too much, or too little, exposure to equities, equity hedging strategies can make sense as part of a long-term strategic asset allocation. Because these approaches can systematically shelter portfolios from volatility, they can serve as a liquid alternative to hedge funds or as a fixed income substitute for investors who are looking to de-risk their portfolios. They also offer investors another way to ease back into equities, with fewer bumps along the way.
Exhibit 1 provides an example of one type of equity hedging strategy that uses both put and call options as a low-cost way to protect stocks. The strategy, broadly known as hedged equity or options overlay, outperformed more tactical hedge fund managers, many of whom reduced their net equity market exposure in 2008 and 2009 and, as a result, missed out on the S&P 500 Index’s subsequent rebound. Simply by staying invested and not trying to time the markets, investors in the options overlay strategy would have reaped a nearly 80% gain since the market bottomed in 2009.