May was a tough month for UK investors, with the FTSE 350 falling by 7.5% and news stories increasingly warning of “Eurogeddon”. In times like these, I find my email inbox increasingly filled with questions about hedging strategies.
However, in reading through the questions, I get the impression that many people have unrealistic expectations for hedging strategies, are confused about what strategies are most efficacious, and have no idea how much a hedge can potentially cost to implement. So I wanted to shed a little light on what makes a good hedge and how to set one up.
Hedging vs. Asset Allocation
Speaking to both institutional and individual investors, I realize too many suffer mainly from asset-allocation problems rather than from hedging problems. Broadly speaking, I have seen two issues: overbetting and oversensitivity.
Let’s start with overbetting. This is the case where someone close to retirement or in retirement already has a large proportion of his portfolio in an overly risky bet (for example, 30% of the portfolio in one or two oil and gas exploration companies). In this case, I believe the best hedge is simply to hit the Sell button on one's brokerage screen. This does not have to be an all-or-nothing decision. Pulling down one's uncomfortably large allocation to a risky bet can be made partially--reducing a 30% exposure to a 5% exposure, for instance. This allows an investor to retain exposure to the potential appreciation of the stock while allowing him to sleep better at night.
Next for oversensitivity. This is characterized by a person who worries and frets about finding some way to protect himself from a loss on what turns out to be a 1% portfolio position. In this case, I suggest that person take a step back and think about the absolute worst-case scenario--the bankruptcy of their risky holding. Remember, if 1% of your portfolio loses 100%, your portfolio overall is only down by 1%.
I hate losing. I hate to be wrong. I understand that seeing a big percentage loss on a brokerage screen can be infuriating, and I would never suggest people make a habit of investing in companies that go to zero. However, one must also retain some perspective on the economic impact of the failure or success of a given investment. If that does not help--if one's risk tolerance is so low that a 1% loss is unacceptably large--see my suggestion above for overbetting and hit the Sell button.
A Good Hedge Is Not a Security Blanket
Assuming an investor is neither overbetting nor oversensitive, he can start thinking about the criteria that make for a good hedge.
One of the biggest mistakes I see people make is treating a hedge as though it were a security blanket. A security blanket is a passive instrument that might serve a welcome psychological role but does not add positive value to the holder. For example, an investor might have hedged appropriately with an index put option just before a market correction. As the market falls, the investor looks at the red numbers on his brokerage screen and feels psychological pressure. However, some of this pressure is ameliorated by one row of numbers--the row representing the market value of the index put--becoming increasingly green. The green row comforts the investor, but he does not realize some or all of the profit on the hedge. The market subsequently bounces back and all the while, the investor is happy because the daily returns for most of his portfolio are green again with only one consistently red position--the index put. The put expires and the investor is no better off than when he began; in fact, he is worse off because he used part of his capital to buy a hedge and realized a loss of capital when that hedge expired.
Contrast this story with the story of a good hedge. The scenario is the same, but when the market falls, the investor realizes some or all of the gains from his hedge and uses those gains to invest in an asset he rationally believes has the highest potential return. He may suffer some uncomfortable days (no one I have ever known in my career calls the exact top or bottom on anything, except by complete random accident), but as the market recovers, he is materially better off. Profits from the put option allowed him to buy an undervalued asset. That asset increased in value at a pace perhaps even greater than that of the market, and when the market rights itself, he is one big step closer to his financial goal.
A Good Hedge Is More of a Bet
When one is investing in a company, one thinks about the potential return offered by that company's stock and the chance that that return will materialize. Hopefully, after considering these factors, the investor decides how much or little of his capital to invest in the idea, within the constraints of his risk tolerance. This simply strikes me as a rational, common-sense approach.
If you agree with me on this, you should agree that a hedge should not be thought of in any different light than a stock investment. In other words, in designing a hedge, you should consider what you would stand to win and the likelihood of winning it, then decide how much of your capital you can allocate to that bet.
Again, this conception of a hedge is very different than the concept of a safety blanket. We are not trying to completely "cover" our portfolio with a hedge but rather fit a new, rational bet into our portfolio.
Many investors think they want a perfect hedge. But a perfect hedge--a hedge that completely shields them from financial loss--will cost so much that they would be better off simply selling their entire stock portfolio and buying US Treasury bonds.
5 Rules of Hedging
In short, the key points to successful hedging can be summed up in a few lines:
- Concentrate first on your asset allocation and rationally assess the necessity of a hedge.
- Decide on the best instrument with which to hedge (for example, shorting stocks, buying single-name option puts, and buying index option puts)
- Come up with a hedging plan.
- Treat your hedges like bets.
- Alter the size of your hedging bets as market conditions change.
