Insight post

Jul. 12, 2018

Keep Calm and Hedge

Keep Calm and Hedge

Why Hedge Your Investments

What comes to mind when you hear the word “hedge”? Hedge funds? Scandals? High risk? Leverage? Fraud?

 

Hedging gets a bad rap. This is unfortunate because it can be an important risk management tool for investors.

What the Hedge?

Hedging does NOT equal hedge fund. Often, the purposes of the two are at odds with one another.

 

Typically, one hedges to reduce the negative impacts of market risk and volatility in a portfolio. The hedge is intended to offset potential losses by transferring risk in various ways (e.g., options, shorting, or futures contracts).

 

 

Say that again? Hedging seeks to reduce and manage risk.

 

Hedge funds’ bad reputation often stems from them taking riskier positions to increase returns by hedging and/or leveraging (borrowing money to place market bets).  These riskier positions are at odds with the stated goal of hedging alone.

Hedging Is Nothing New

Hedging has been around a long time. Farmers, airlines, banks—they all hedge to manage the biggest risks in their businesses. Farmers hedge against changes in seed, livestock and crop prices. Airlines hedge against big changes in oil prices. Banks hedge against interest rate risk.

 

If you own car or home insurance, you are essentially hedging against potential property loss either due to a car accident or housing catastrophe.

 

Diversifying your portfolio can sometimes appear like a form of hedging. For example, many investors buy bonds to offset potential losses in stocks with the expectation that bonds, and stocks are uncorrelated and won’t move in the same direction at the same time. This, however, hasn’t always been the case. Remember the 2008 Financial Crisis? Many types of bond funds lost value at the same time as nearly every category of stocks.

 

According to Investopedia, “market risk…cannot be eliminated through diversification, though it can be hedged against.” Diversification alone isn’t enough to manage market risk.

Protect Your Assets

As hedging is meant to reduce risk and volatility, the goal is to lose less money in your investments, especially during times of major market stress. If your portfolio spends less time recovering, it may spend more time compounding.

 

Some common ways to hedge involve market timing, short selling, futures contracts, and options.

 

Marketing timing and short selling depend on one’s ability to successfully and repeatedly “predict the market.” It is difficult to consistently time when to buy or when to sell across all holdings in a portfolio, making this approach an undependable risk management approach.

 

Put options, on the other hand, may be a good option for those looking to protect their assets from inevitable, but unpredictable times of major market stress.

Keep Calm and Hedge

You know investing can be a bumpy ride. Hedging may be a way to create a smoother ride.

 

The key to a hedging strategy is to take an uncorrelated offsetting position relative to some asset (stock, etc.).

 

Put options on an asset are especially effective for hedging since a put option is inversely correlated to the asset itself. For example, when you use a put option on a stock, if the stock price goes down, the value of the put option goes up, and vice versa.

 

We believe that put options are much more effective in managing and reducing risk than other forms of hedging. They offer control over the hedging process, are inversely correlated to the asset they seek to protect, may reduce adverse investor behavior, and offer profit potential.

 

Some may shy away from mutual funds or other investments that use options due to unfamiliarity with options or their capabilities. Hedging, however, offers a direct way to address market risk. A hedged equity approach defines and manages risk via put options may be beneficial for investors who want to:

 

  • Remain invested

  • Reduce overall portfolio risk

  • Seek protection in times of major market stress

 

Market risk is too important of a threat to be dealt with passively.

Win by Not Losing

Hedging doesn’t have to be only for airlines and banks. Investors should consider incorporating a hedged equity strategy in their portfolios to help manage and balance the risk from other investments. But how does one vet and select a hedged equity strategy?

 

A hedged equity strategy should have the following attributes:

 

  1. Its main goal is to reduce and manage market risk.

  2. It has a transparent and rules-based strategy.

  3. The strategy has weathered times of major market stress.

 

The goal of our Defined Risk Strategy, a hedged equity approach, launched in 1997, is to produce consistent returns through ups and downs of the market. By tackling market risk head on, the Defined Risk Strategy seeks to help investors remain always invested for growth, while remaining always hedged to reduce losses in times of major market stress.

About the Author:

David Lovell, Director of Marketing, is responsible for all of the company’s marketing, communications and engagement initiatives. This includes the development and execution of all marketing programs for Swan’s websites, content, communications, events, and media. David began his career in the financial industry at Mass Mutual. David currently holds a Series 65.

Important Notes and Disclosures:

Swan Global Investments, LLC is a SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (“DRS”). SEC registration does not denote any special training or qualification conferred by the SEC. Swan offers and manages the DRS for investors including individuals, institutions and other investment advisor firms. Any historical numbers, awards and recognitions presented are based on the performance of a (GIPS®) composite, Swan’s DRS Select Composite, which includes non-qualified discretionary accounts invested in since inception, July 1997, and are net of fees and expenses. Swan claims compliance with the Global Investment Performance Standards (GIPS®).

All Swan products utilize the Defined Risk Strategy (“DRS”), but may vary by asset class, regulatory offering type, etc. Accordingly, all Swan DRS product offerings will have different performance results due to offering differences and comparing results among the Swan products and composites may be of limited use. All data used herein; including the statistical information, verification and performance reports are available upon request. The S&P 500 Index is a market cap weighted index of 500 widely held stocks often used as a proxy for the overall U.S. equity market. Indexes are unmanaged and have no fees or expenses. An investment cannot be made directly in an index. Swan’s investments may consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use. The adviser’s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of particular ETFs and options in which the adviser invests or writes may prove to be incorrect and may not produce the desired results. There is no guarantee any investment or the DRS will meet its objectives. All investments involve the risk of potential investment losses as well as the potential for investment gains. Prior performance is not a guarantee of future results and there can be no assurance, and investors should not assume, that future performance will be comparable to past performance. All investment strategies have the potential for profit or loss. Further information is available upon request by contacting the company directly at 970–382-8901 or www.www.swanglobalinvestments.com287-SGI-071218