2017 was a pretty atypical year, especially in terms of equity returns (S&P 500® Index ended up 21.82%). So as we ring in the New Year, many cautious investors are looking over their shoulders. Has irrational exuberance returned and if so what’s next?
To Hedge or Not to Hedge
Some may be pondering a reversion to the mean in the equity market. That would imply more challenging markets lie ahead. For this group equity hedging may be at the forefront of their thoughts. Interest in equity hedging tends to increase in environments like the current one; after the market has experienced a strong rally and volatility is low. The last calendar year when the S&P 500® Index total return was negative was 2008 — when it declined 37.0%. Since then the index has appreciated 258.2%, or 15.2% annually, over the last 9 years. We all know that trees do not grow to the sky.
Timing is Everything
So is now the right time to hedge your equities? Well, it depends. Historically the cost of implementing an ongoing equity hedge has been significant which can be a hurdle. In general someone implementing an equity hedge needs to time it correctly or else negative carry from hedging will overwhelm any potential benefits.
To be certain there are times when hedging is absolutely appropriate. For example, an external event like the corporation selling a division, may create the need for a short term reduction in risk and hedging can be a solution. However, most people pursue hedging for more tactical reasons. This decision is based on concerns about the current market environment. Rather than being driven by a specific and defined event it’s due to a belief that markets are overvalued and a hedge will likely improve short-term returns.
The primary goal of an equity hedging program is the reduction of a portfolio’s drawdown associated with a market selloff. There can be secondary goals as well such as reducing portfolio volatility, eliminating negative skew and improving the Sharpe Ratio. All these potential benefits come with costs. The challenge for any investor is determining if the benefits associated with hedging a portfolio outweigh the expected costs.
If you do choose to hedge, equity options can be a good option. Equity index puts and calls are typically used in various combinations to create hedging strategies. But note that no single hedge structure performs best in all market environments and all tend to have net expected costs under most scenarios.
The bottom line
On the surface, equity hedging may appear to offer an attractive alternative for those investors concerned about the market after a strong rally. Who wouldn’t want to mitigate drawdowns after the market has experienced an extended bull run?
However, hedging has a cost and, historically, that cost has been significant. If you are pursuing a hedge simply because you are nervous about the market level pump the brakes. A successful equity hedging program requires timing the market correctly and markets can remain overvalued for years. Recall Alan Greenspan gave his irrational exuberance speech 3 years before the tech bubble burst. A failure to time the market event correctly will lead to reduced return and, likely, investor frustration so proceed with caution.
Fear Is Not An Option: Learn the Basics
Everyone’s heard of options, but what exactly are they and why might you consider using them? Options may seem complicated but they don’t have to be intimidating. Get a refresher on options and how you might use them in our latest blog post by Tom Lee.
Potential Parametric Solution
Our Volatility Risk Premium (VRP) Strategies aim to provide a persistent source of return without the use of leverage or market forecasts. They do so by harvesting the VRP, a well-researched phenomenon based on the discrepancy between the implied and realized volatility of equity index options. Parametric has developed a series of sophisticated VRP strategies in an effort to meet different investor objectives.
Tom Lee, CFA, Managing Director, Investment Strategy & Research
Mr. Lee leads the investment team that oversees investment strategies managed in Parametric’s Minneapolis and Westport Offices. In his current position, Tom directs the research efforts that support existing strategies and form the foundation for new strategies. He is also chair of the Investment Committee that has oversight of these strategies. Tom has co-authored articles on topics ranging from liability driven investments to the volatility risk premium. Prior to joining Parametric in 1994*, Tom spent two years working for the Federal Reserve in Washington, D.C. He earned a B.S. in Economics and an MBA in Finance from the University of Minnesota. He is a CFA charterholder and a member of the CFA Society of Minnesota.
*Reflects the year employee was hired by The Clifton Group, which was acquired by Parametric Portfolio Associates® LLC on December 31, 2012.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.