Optimizing Equity Hedging: Case Study and Current Market Pricing Insights

In our recent Mid-Year Investment video, we described equity valuation metrics at historically high levels, the risk of Fed policy errors increasing, and Investment Road Signsᵀᴹ that serve as guidance for our proprietary risk management system becoming more prevalent.

Given this increasing risk environment, implementing a hedge investment strategy allows us to reduce portfolio risk without making specific stock market timing calls, which cannot be done consistently.

The following chart shows the range of investment outcomes of a recently priced hedge investment which is based on the difference in the starting and ending value of the S&P 500 over two years:

In the example above, this strategy increases the positive range of outcomes between the S&P 500’s ending value if flat, down to a loss of 20%. The hedge produces a positive return equal to any negative ending S&P 500 value, stopping this positive-for-negative return swap at a negative 20% drop in the index.

Furthermore, for any ending value result lower than 20% in the S&P 500 ending value, the hedge still produces downside protection of 20% at maturity. This means if the S&P 500 decreases 30% in value, the hedge return is a negative 10% at maturity (saving 20% of the drop in value of the S&P 500).

To achieve these return advantages mentioned above, the strategy will not participate in any positive ending value of the S&P 500 north of 20% at maturity. For example, if the ending value of the S&P 500 is 30%, 40%, or even 50%, the payout at maturity will remain at 20%.

It is important to understand that the hedging strategy described above is a structured note investment. This means there are additional risk considerations such as issuer credit risk, illiquidity risk, and dividends not being part of payment at maturity. Along with a detailed explanation of any structured note investment chosen for your portfolio, these risks can be found in an accompanying preliminary prospectus provided to all investors.  

In summary, this investment provides a wider range of positive outcomes (compared to the S&P 500 Index) from the cap price (+20%) to the floor price (-20%) at maturity. Additionally, the downside buffer of 20% at maturity adds meaningful protection in case the ending value of the S&P 500 drops below 20% over this period.

Have questions or want to speak with our team directly? Contact us.

Robert Amato, CFP®, CIMA®

Principal

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Compass Wealth Management is a Registered Investment Advisor. Advisory services are only offered to clients or prospective clients where Compass Wealth Management and its representatives are properly licensed or exempt from licensure. This article is solely for informational purposes and is not intended to be relied on as a forecast, research, or investment advice, and is not a recommendation, offer, or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by Compass Wealth Management to be reliable, are not necessarily all-inclusive, and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investments involve risks.