What is a Portfolio Hedging Strategy and How Does It Work?
A hedge is an investment that is made to reduce the risk of adverse price movements in an asset. Here at Compass Wealth Management, we use a hedge to narrow the range of outcomes in the equity portion of clients’ portfolios.
A hedge investment will typically be swapped for a portion of your equity position in your portfolio and usually has a defined term (1-3 years). The hedge provides market downside protection at maturity in return for potentially giving away market upside if the market ends up doing better than expected over this period.
For example, the chart above illustrates a hypothetical three-year hedge strategy with 20% market downside protection and a total upside return cap of 50% at maturity. The left column represents the principal return percentage at maturity of the S&P 500, and the right column represents the principal return percentage of the hedging strategy at maturity.
At the top of the chart, you can see that if the stock market returned 200% of its initial principal over three years (doubling your money) then your hedge investment would return only 150% of its initial principal, essentially missing out on half of the market upside over this time period (please reference the green box above). Keep in mind this is still an average gain of over 16% per year which is not bad! However, if the stock market only returned 80% of the initial principal at maturity you would have lost 20%, but in contrast, the hedge investment returns your full principal invested (please reference the blue box above).
Lastly, if the stock market only returns 75% of the initial principal over maturity, you would lose 25% if invested without a hedge. The hedge investment returns 95% of your principal (please reference the red box above) in this instance and continues to provide you with a 20% downside buffer if the market loses more. Hopefully, this example provides you with a better understanding of how these investments provide downside market protection in return for giving away some upside in a very good market.
There are some additional considerations for using a portfolio hedging strategy:
If the hedge is implemented using a structured note, which is our most common way to implement this strategy, then you do take on the additional credit risk of the issuer with this investment. To mitigate this risk, our firm uses a selection of the largest US banks such as JP Morgan, Bank of America, Goldman Sachs, etc. Additionally, these are banks that all survived the 2008 global financial crisis.
Once you enter the note you cannot change the terms and this portion of your portfolio should be considered illiquid until maturity.
These hedge investments typically do not pay dividends. For example, the S&P 500 currently has an annual dividend of 1.5% - so over three years you would lose around 4.5% of your return compared to owning the index outright.
Lastly, if the underlying index is positive at maturity, the note will payout your principal in addition to the gain which is a taxable event in a non-qualified account, unlike owning the index and controlling when any gains would be realized. Therefore, this strategy can be much more efficient in retirement accounts for more tax-sensitive clients.
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.