Manage Volatility by Using Liquid Alts To Hedge Equities

After the 2008 financial crisis, institutional investors recognized that market volatility and high correlations among asset classes called for a revised approach to portfolio allocation. In response, many state pension funds reduced unhedged equity risk in their portfolios by sharply increasing allocations to alternatives, some in the form of hedged equities.

Individual investors, on the other hand, continued a traditional allocation with comparatively more unhedged equities, much more cash, and much less in risk-managed strategies such as alternatives.

Individual investors’ high allocations to cash—on average 15% of assets—essentially showed a simpler reaction to the same issues that prompted institutional investors to increase allocations beyond long-only strategies.

In our view, a more strategic response for individuals would be to increase exposure to hedge equities. We believe that increasing exposure to hedged equity strategies may provide the downside protection—and therefore emotional reassurance—that individual investors need to stay in the market. Why? This allocation strategy helps address market volatility. With potential for downside protection in place, investors may avoid running to the sidelines and missing out on gains—as happened during the bull market that began in 2009.

By making the decision to hedge a portion of their unhedged equity holdings, investors may be better able to stay the course and weather the storms. This way, hedged equities can serve as tools to address the human response to market conditions. This may be increasingly important given the historical shift of “typical” market behavior toward higher structural volatility.

Correlations and Diversification

Higher correlations among assets have also increased the inherent risk of unhedged equities.

The organizing principle of Modern Portfolio Theory (MPT) is that combining assets with low correlations to each other can reduce portfolio variance and improve risk-adjusted returns. For example, many investors diversify their equity exposure internationally, with both developed and emerging market holdings.

Prior to 1990s, the long-term correlation between international (developed) equities and the S&P 500 Index was under 0.50. The pre-1990 value for emerging markets was even lower, at 0.18. These relatively low correlations allowed meaningful diversification while staying within equities as a broad asset class.

correlations between equity markets have been rising for decades

Source: Morningstar and William Coaker, Investments & Wealth Monitor, July/August 2011. Data for period prior to 1990 is based on most recent of inception date of index or period from 1970-1989. International and Emerging Markets are based on the MSCI EAFE and MSCI Emerging Markets. ©2019 Van Etten Consulting, Inc. All Rights Reserved.

Portfolio Variance is the measurement of how the actual returns of a group of securities making up a portfolio fluctuate. Portfolio variance looks at the standard deviation of each security in the portfolio as well as how those individual securities correlate with the others in the portfolio.

Note how much correlations have risen in the last 25 years. Now, the S&P 500 Index is highly correlated to both international developed and emerging markets.

Such increases in correlations may underscore the need for including hedged equity strategies in a well-diversified portfolio. As a risk management tool, hedging offers significant benefits relative to solely diversifying across types of equities. Given that the majority of risk in a diversified equity portfolio is market-based risk (rather than company-specific risk), it cannot be diversified away in a long-only portfolio. However, hedged equities, by design, can address market-based risk.

Long/Short Equity and Covered Call Writing

Two types of equity strategies may be especially useful to investors seeking to hedge a portion of their equity exposure.

» Long/Short Equity: Managers of long/short equity strategies seek to benefit from stocks that are appreciating in price as well as from those that are declining in price.

» Covered Call Writing: Managers of covered call strategies seek to reduce risk and generate income from:

  • Writing call options against long equity positions
  • Purchasing puts to provide downside protection to the portfolio

For more information, see:

Return to the Volatility Guide



Disclosure

This material is distributed for informational purposes only. The information contained herein is based on internal research derived from various sources and does not purport to be statements of all material facts relating to the information mentioned, and while not guaranteed as to the accuracy or completeness, has been obtained from sources we believe to be reliable.

Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.

RISKS OF ALTERNATIVE STRATEGIES

Alternative investments may not be suitable for all investors, and the risks of alternative investments vary based on the underlying strategies used. Many alternative investments are highly illiquid, meaning that you may not be able to sell your investment when you wish to.

Long/short equity: The principal risks of investing in long/short equity strategies include: equity securities risk—securities markets are volatile and market prices may decline generally; short sale risk—a portfolio may incur a loss without limit as a result of a short sale if the market value of the security increases, a portfolio may be unable to repurchase a borrowed security; leverage risk—certain transactions such as loans and securities lending may create leverage and cause the fund to be more volatile; foreign securities risk—fluctuations of exchange rates may affect the U.S. dollar value of a security.

Covered call writing: As the writer of a covered call option on a security, the fund foregoes, during the option’s life, the opportunity to profit from increases in the market value of the security, covering the call option above the sum of the premium and the exercise price of the call.

Some of the risks associated with investing in alternatives may include hedging risk – hedging activities can reduce investment performance through added costs; derivative risk- derivatives may experience greater price volatility than the underlying securities; short sale risk - investments may incur a loss without limit as a result of a short sale if the market value of the security increases; interest rate risk – loss of value for income securities as interest rates rise; credit risk – risk of the borrower to miss payments; liquidity risk – low trading volume may lead to increased volatility in certain securities; non-US government obligation risk – non-US government obligations may be subject to increased credit risk; portfolio selection risk – investment managers may select securities that fare worse than the overall market. Alternative investments may not be suitable for all investors.

Before investing carefully consider the fund’s investment objectives, risks, charges and expenses. Please see the prospectus and summary prospectus containing this and other information which can be obtained by calling 1-800-582-6959. Read it carefully before investing.

NOT FDIC INSURED | MAY LOSE VALUE | NO BANK GUARANTEE

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