When it comes to the world of investing, unforeseen market events can potentially have catastrophic outcomes for investor portfolios.
By Prateek Nigudkar
Insurance as a concept has been around for several centuries now. Earliest documented insurance contracts were for Greek merchants, who sought of a way to protect them from losses, if their provision aboard the ships were lost at sea. The relative success of maritime insurance, in helping merchants avoid catastrophic losses led to the evolution of other insurance products, such as fire insurance and life insurance in the 1600s.
Since then, insurance products have penetrated all parts of our lives. Most people now have some form insurance such as health insurance, life insurance or property insurance. The idea of paying a small fee in return of an assured sum in an unfortunate event of peril seems to be a sound idea for most people.
When it comes to the world of investing, unforeseen market events can potentially have similar catastrophic outcomes for investor portfolios. Unfortunately, however, unlike other walks of life, when it comes to investing, portfolio insurance is often seen as being ‘optional’. The utility of portfolio insurance or hedging is often trivialized and the cost of insurance is viewed as drag on potential returns. Overconfidence in one’s ability to avoid catastrophic losses and the failure to appreciate the frequency of these sharp market drawdowns is another reason why most investors do not hedge their portfolios. The stigma associated with portfolio hedging therefore often leads to suboptimal portfolio outcomes
Why is Portfolio insurance/hedging and why is it necessary?
Portfolio hedging is a way to prevent or partially mitigate losses arising from extreme market events. The last 20 year of equity market data is littered with events that have resulted in sharp market falls.
These days of extreme loss can have debilitating impact on investor portfolios and psyche. Needless to say, if one were to minimize losses on such days, there is a huge positive bearing on long-term returns. Lower portfolio drawdowns also significantly increase utility for risk-averse investors and helps them stay invested instead of panicking and selling off at the worst possible time.
Other than reducing drawdowns and the risk of ruin, hedging has several other advantages. Hedging and other portfolio insurance strategies help in providing a source of liquidity post market selloffs when valuations have become attractive and incremental deployment in risk assets becomes more favorable from a risk reward standpoint.
Hedging is also critical for retirees and pensions where withdrawal rates increase non-linearly with portfolio drawdowns and where large scale portfolio drawdowns can potentially derail financial goals.
Lower interest rates now mean that fixed income instruments now yield much lower than before. Consequently investors have no choice but allocate more to riskier assets such as equities to meet their financial goals. Portfolio hedging helps investors allocate more to riskier assets such as equities without embracing higher risk of substantially higher portfolio drawdowns.
Higher equity valuations in the past have also resulted in sharp market corrections. As equity valuations currently close to all-time-highs, it’s even more imperative to consider portfolio hedging strategies right now. Investors must continue to work with their advisors and fund managers around ways to mitigate the potential of a large drawdown if such a fall were to happen.
The ‘myth’ of Diversification
Financials literature is replete with information about benefits of diversification. While some of that is indeed true, diversification is not a cure for all ills. Instead, owning a diversified portfolio often gives the investor a false sense of comfort that they are immune to extreme outcomes.
Unfortunately, diversification often fails to work when you need it the most. A diversified portfolio is designed to function well only in normal times. When markets enter phases of extreme uncertainty, asset prices start witnessing higher volatility. During period of such high volatility, asset correlations jump higher making the benefits of diversification vaporize quickly. During such times even seemingly well diversified portfolio experience sharp drawdowns.
The events of March 2020 are perfect example of this kind of a cascade. The unwinding of leveraged positions and margin call related selling resulted in sharp selloffs across the globe with all major asset classes such as Equities, Bonds and Commodities correcting at the same time leaving even well-diversified portfolio holders with sharp losses.
Investors and financial advisors must be on the lookout for funds that fall appreciably less during such market turmoil as such funds have likely made use of superior hedging strategies. While it is not a given, the instruments used by such hedging strategies can be looked up in monthly portfolio disclosures in the form of either short positions in the index futures, select stocks or existence of index Put options in the portfolio
Different approaches to Tail Hedging/portfolio insurance
The choice of a Tail-Hedging strategy is essentially a tradeoff between magnitude, certainty and cost of portfolio insurance. Higher magnitude and higher certainty of protection entails a higher cost. Having cash/cash like instruments in the portfolio for instance is a relatively low cost strategy with a reasonably high degree of certainty of providing portfolio protection. It however has a low magnitude of protection and in most cases won’t be sufficient to offset losses from rest of the portfolio. On the other hand, long volatility strategy (option buying) has steep costs associated with it but also bring about a high degree of certainty of protection and higher magnitude of protection. Hence the choice of a tail hedging strategy is a function of suitability and portfolio level objectives.
Given the limitations of conventional portfolio diversification in extreme market conditions, it becomes important to have portfolio allocation to an asset class or a strategy that is able to truly diversify and one that has a strong negative correlation to the rest of the portfolio. A thoughtful allocation to long volatility instruments such as put options helps in creating anti-fragile portfolios as it provides a higher magnitude of and certainty of protection in extreme market declines thereby insulating portfolios from shocks. Investors keen on such strategies should look for investor presentations and fund factsheets to gain more insights into funds employing such strategies. A constant dialog between investors/advisors and the fund manager also help in gaining more insights into the existence of hedging strategies (if any) and also more color on how the fund manager goes about implementing the strategy as well as the preferred choice of hedging instruments.
(Prateek Nigudka works with the Quantitative Strategy team at DSP Investment Managers. The views expressed are the author’s own. Please consult your financial advisor before investing.)