Now’s The Time To Consider These 7 Hedging Strategies

October 20, 2017

Now’s The Time To Consider These 7 Hedging Strategies

  • A hedge is like any other investment. Whether it’s good or bad depends on the price.
  • I’ll discuss 7 unconventional strategies that will give you some food for thought.
  • The best hedge is the free hedge. By looking deep enough, it’s possible to find it.



Introduction

Hedging is a very important, but an often-omitted investing strategy.

The principle of hedging is to own something that will go the opposite direction of everything else in the case of a market crash, protecting your portfolio from potential losses. For example, if you own an S&P 500 portfolio, buying a put option on the S&P 500 gives you security in the event that the market falls as you won’t lose anything as the value of the put option should appreciate at the same rate the S&P 500 declines.

The issue with hedges is that they usually aren’t free, and often have an expiration date on them making them very expensive to maintain over longer periods of time.

In today’s article, I’ll discuss a few interesting hedging strategies and will show you how they can be applied by the rational investor.

Diversification As A Hedge

The most common hedge is diversification, but diversification means owning uncorrelated assets.

The public opinion about proper diversification is owning the S&P 500 while extreme diversification means owning bonds and stocks. The truth is that both stocks and bonds move in tandem, and opposite to interest rates.

Since 1982, interest rates have been declining, pushing down the required returns and, consequently, inflating asset prices. Therefore, if you want to grasp the benefits of diversification hedges, you should really look for uncorrelated assets.

You can read more about assets and economic environments in our all-weather portfolio article. Diversification assets include commodities, stocks, emerging market stocks and credit, inflation protected bonds, etc.

Hedging For Financial & Economic Turmoil

As we all know, the economy and financial markets work in cycles which are usually fueled by debt.

At some point, consumers and businesses over leverage themselves, the cost of the debt becomes a burden, and economic activity slows down. Depending on the situation, an economic slowdown can have mild repercussions or terrible repercussions.

The economic slowdown of 2008 had terrible repercussions as the whole global financial system was put in turmoil. Given that since then central banks have constantly been adding liquidity to the system, the next financial crisis could be even worse and the only thing we can expect is that central banks will continue to administer the same medicine they have been using, i.e., more money printing.

I call it “money printing,” but the formal name is quantitative easing, a practice that includes lowering interest rates, increasing credit, offering tax credits, and buying assets on financial markets.

Figure 1: The FED’s, ECB’s, and BOJ’s assets have all increased around 4 times in the last decade. Source: FRED.



It’s easy to conclude that in the next recession, central banks will do, to quote ECB president Mario Draghi in 2012, “Whatever it takes” to keep the situation as it is. This predictability offers a great opportunity for the rational investor to be hedged against more money printing.

The best hedges against quantitative easing are assets that are fixed in supply like precious metals, fixed supply real estate like land, and commodities that have a fixed supply but stable demand.

Gold as a metal is very volatile in the short and medium term but in the long term, it follows the money supply. Gold prices have appreciated about 6 times in the last 15 years, which is close to the FED’s balance sheet increase.

Figure 2: Gold prices in the last 20 years. Source: Macrotrends.

Read more about gold in our article on how the precious metal could go to $20,000 per ounce.



Hedging Against Inflation

A big surprise for economists was that quantitative easing policies didn’t lead to high inflation rates. Nevertheless, inflation is always around the corner and could show itself at any point in time.

Inflationary hedges are similar to the hedges for quantitative easing. However, another excellent inflationary hedge is a fixed interest loan. Given that all governments have the goal of getting to an inflation rate of at least 2% with 3% being a good balance, a fixed interest long term loan would provide a great hedge for inflationary pressures, especially if the money is invested in hard assets with a stable safe yield that increased alongside inflation. Our article on good debt explains how to take advantage of loans.

TIPS, Treasury inflation-protected securities, are other interesting inflation-protecting securities.

Hedging For Currency Risk

Most take their own currency for granted, but proper diversification includes currency hedges and exposures that even out through time.

It’s often overlooked, but the U.S. dollar has lost 40% of its value in comparison to a basket of major global currencies in the last 30 years.

Figure 3: The dollar index. Source: FRED.

As currencies usually move in cycles of a few years, the best strategy is to have a well-diversified international portfolio and then rebalance the weights according to the strength of the currency.

A strong dollar doesn’t do well for the U.S. economy and sooner or later, it has an effect. Nevertheless, the rational investor can take advantage of the strong domestic currency and buy international assets on the cheap. Consequently, international assets have to be rebalanced when the foreign currencies look strong in the long-term cycle in relation to the domestic currency.

Liquidity Hedges

Another often overlooked hedge is having a cash cushion.

Cash is the ultimate hedge as it allows you to take action when a great opportunity shows itself. However, it takes a lot of patience to have a significant part of a portfolio in cash and the discipline to invest it only at certain levels of return.

For example, let’s say the earnings yield of a well-diversified portfolio is now 10% and a rational investor has 25% of their portfolio in cash or short term highly liquid assets like T-Bills. If the earnings yield drops to 7.5%, the investor might want to increase their cash position to 35% or just keep it at 25% by selling some other relatively overvalued assets.

When the portfolio yield increases to 15% as often happens in stock market crashes, the rational investors could significantly lower their cash exposure in order to take advantage of the bargains available.



Remember, cash is power, but power often goes to people’s heads.

Hedging Outside Of Financial Markets

Most investors are often focused on their portfolios because watching a portfolio move on a daily basis is entertaining. However, there are many other opportunities to invest in that are far from the stock market but are equally important in a well-diversified hedged portfolio.

I’m talking about private equity, perhaps starting your own business, a side income thing, buying a farm as a hedge in order to assure shelter and food, real estate, and many other things that we don’t think about that much. This list might sound funny, but investing isn’t only about the stock market, it’s about finding the best risk reward opportunities and by always keeping our eyes open as opportunities might come from all kinds of places. So, keep your eyes open.

The Most Popular Hedging Method – Options

I’ll finish this list with the most popular hedging contract, options.

Some say options are good, some think otherwise, but the main point is that it all depends on the price of the option. It often happens that an option to insure an investment is very cheap because the market thinks there is no risk in the given asset. That’s usually the case when the asset is overvalued. So a rationale investor might use options in order to hedge a position that perhaps appreciated significantly in the past and now is overvalued. However, an option can protect the downside and can be a great insurance if it is cheap. The lower market volatility is and the higher investors’ complacency is, the cheaper options might be.

For example, as I’m writing this in October 2017, the December 2019 put option on the S&P 500 costs 8.7% of the index. Thus, by buying such a put now, you are assured your S&P 500 downside is maximally 8.7% of your portfolio while you keep getting dividends and are open to the potential upside. The lower the VIX index is, the cheaper those put options will be.

Figure 4: S&P 500 December 2019 option chain. Source: Nasdaq.

As an 8.7% decline at this moment in time seems highly unlikely, the put option for someone that hasn’t the luxury to go through volatility doesn’t seem like a bad idea. A lot of things can happen in the next two years and two months.



A Hedge Is Like Any Other Investment, It Can Be Cheap Or It Can Be Expensive

A hedge is like any other investment and has to be approached the same way.

It’s important to understand the cost of a hedge and attach carefully calculated probabilistic outcomes to that hedge. When a hedging option seems cheap from a risk reward perspective of the individual portfolio, it isn’t a crazy thing to take advantage of it.

Further, there can also be hedges that carry alpha. For example, I always have a gold hedge in the form of gold miners in my portfolio. But it’s even better if I can find a miner that mines both copper and gold at low cost, or where the copper production is somewhere in the future and currently heavily discounted by the market. In this way, I’m protected both against financial turmoil with the gold and eventually also against inflation with the copper, even if gold prices stumble.

I firmly believe it’s possible to create a well-hedged portfolio in any environment with every hedge creating value in the form of a yield, be it a dividend from a low-cost gold miner or interest on foreign debt. Such a portfolio with proper rebalancing should bring about lower risk and higher rewards over the long term.

Keep reading Investiv Daily as I’m always discussing interesting opportunities to lower your risk and increase your returns.