If the stock markets declined by 40% or more, how would your portfolio be impacted?

A large market decline does not have to mean large losses for your investments. Hedging can be a useful tool to minimize downside risk and protect your portfolio against losses.

What is hedging?

Hedging usually involves buying securities that are inversely correlated to the securities in your portfolio.  Meaning that, if your investments decline in value the hedging securities will offset losses. Hedges are essentially insurance policies against large investment losses.

The downside of hedging

You might be wondering: if hedging is so great, why doesn’t everyone do it?

Well, the downside is that like insurance, hedging is not free and there is a cost. Depending on the method, hedging may cost a small price and/or an opportunity cost.  Regardless, there will be some minor impact on portfolio returns.

Recall, hedging requires buying securities that are inversely correlated with your investments.  This works both ways: your hedge will increase in value when you investments decrease, but it will decrease (or stay flat) in value when your investments increase.

For example, you could hedge your portfolio of investments by moving 25% to cash.  If the value of your investments (75% of your portfolio) increased by 12% in a year, your total portfolio performance is only a 9% gain because the cash would not increase in value. The hedge cost you a 3% in opportunity cost.

Ways to hedge investments

There are many ways to hedge your investments.  Different hedging methods can provide different results which can be tailored to the specific situation and the risk tolerance of the investor.  Some methods are also more or less “expensive” than others (more on this later). We’ll explore three primary methods here: holding cash, buying options, and buying tail risk instruments.

1) Holding cash

Holding cash is one of the simplest methods to guard against a decline in portfolio value.  However cash has it’s own risk: inflation. Cash only provides limited hedging protection because cash is not correlated with stocks (positively or negatively).

You can allocate a portion of your portfolio to cash which will be protected, but the rest of your portfolio will remain at risk.  There is no upfront cost for being invested in cash, but there is the opportunity cost of a portion of your portfolio not being invested in the market.

Note: by “cash” I really mean liquid cash equivalents like very short-term treasury bonds or money market accounts where you can make some interest.  You should never hold very much actual cash in your investment portfolio.

2) Buy options

Derivatives such as options are another popular way to hedge as you can directly purchase securities that will perform inversely of your investments.  For example, if you own an S&P 500 index ETF in your portfolio, you can hedge by buying out of the money put options on the same ETF.

Buying options is a very effective hedging tool because options are inherently strongly inversely correlated investments. By definition, put options are inversely correlated to the underlying security.  With options you can also tailor the level of protection while balancing the cost you are willing to pay by selecting options with different strike prices and expiration dates.

The price of options can vary depending on multiple factors such as how close the trading value is to the strike price, the remaining time on the option, and the volatility of the underlying security and the market.

3) Buy tail risk securities

Investors can also use specialty ETFs that seek to mitigate downside risk.  These ETFs use a variety of securities, including derivatives / options (like the method described above), to perform inversely to the market.  These ETFs are an easy way to buy a security that will protect your investments, without having to worry about learning to buy put options. A nice option for investors who do not want to nor have the time to learn options.

Tail risk ETFs are a more effective hedge than cash because they are inversely correlated to equities. Therefore you will not need to allocate as much of your portfolio to these ETFs as you would need to with cash for the same protection. These ETFs will increase in value if the markets decline in value. However these ETFs can impact portfolio returns because they will decline in value during bull markets.

The Cambria Tail Risk ETF is one example of a tail risk fund.  This ETF inversely correlates to the S&P 500 (SPY ETF shown below).  The correlation of daily returns over the past year is -0.80.

The Cambria Tail Risk ETF is inversely correlated to the SPY ETF

Comparison of hedging methods

Using put options to hedge a portfolio is generally my preferred hedging method because of the effectiveness and flexibility to tailor hedge to my risk tolerance.  However, tail risk ETFs and cash are also useful in certain situations.

MethodCostEffectiveness
CashModerateLimited
OptionsLow to moderateHigh
Tail Risk ETFModerateModerate
Cash, options, and tail-risk funds are three hedging strategies to protect your investments Click To Tweet

Below is an example of three market drawdowns, 20%, 40%, and 60% (yikes!).  The example shows an estimate of what each of these strategies might cost (opportunity and real cost combined) and how they would perform in each scenario. All percentages are percentage of total portfolio.

Options perform better than cash and tail risk ETFs at limiting losses for large drawdowns and is estimated to be slightly less costly than the other options. But note that this can vary based on specific option pricing.  Cash and tail risk ETFs perform better than options during smaller market drawdowns.

Comparison of hedging methods

Hedging strategy application

Hedging is not necessary in all market environments and for all types of investors.  If 1) you believe market conditions make the possibility of a market correction more likely and 2) you cannot accept the drawdown risk and portfolio losses, then hedging might be an option for you.

Ultimately you must decide as an investor if and when hedging is the right strategy.  Then you can select the best hedging method based on your investing objectives and risk tolerance.

How to protect your investments with hedging strategies Click To Tweet

How to protect your investments with hedging
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