What are the different strategies to hedge your portfolio?
Head of Equity Strategy
Summary: With the equity market on edge due to an energy crisis and severe growth slowdown in China it is natural to begin thinking about reducing portfolio risk. There are many different ways to reduce portfolio risk and we go through some of the most popular methods including novel approach using market makers.
Given the ongoing global energy crisis and its potential ramification for future inflation and an interest rate shock it is prudent to go through the various strategies available to hedge and reduce risk in the portfolio. We have warned of risks building in equities for over a month in many of our equity research notes and yesterday we dived into using market makers as hedging components. But before we go through the different strategies available to investors we should set the framing right.
Most investors have single stocks portfolios consisting of 3-10 stocks which provide little protection against market risk. Take our green transformation basket which consists of 40 stocks with exposure to the green transformation theme. This basket has had a beta of 1.33 to the MSCI World using weekly observation over the past six years meaning when global equities are down 10% this portfolio is down 13.3% on average. Now many retail investors have only 10 stocks or fewer which means that their beta to global equities is maybe 1.5 or even 2. In the event of global equities correcting 20% such a portfolio could experience a 30-40% decline. The problem is that most individuals have a hard time coping with big losses which leads to subsequent bad portfolio decisions.
Cash is king or is it?
The most effective and least complicated way to reduce market risk is to increase one’s cash position by selling some positions. However, going to cash involves market timing and costs related to reduce many different positions. Secondly, the investor will constantly be in a position of when to add again getting the upside, and most of time this is almost impossible. The upside of going to cash is that it does not require any advanced instruments such as futures or options.
Diversification is the only “free lunch”
There are few free lunches in financial markets but one of them is diversification across multiple stocks. Diversification reduces the overall volatility of the portfolio and reduces the impact on the portfolio from a single stock and the marginal benefit of adding a stock in the portfolio diminishes greatly around 20-40 stocks. Many retail investors do not have the time or money to diversify over 30 stocks. In that case the second best option is to buy an ETF on the MSCI World index or several ETFs across different asset classes and then add a few single stocks on the side. In this way you get your beta closer to 1 (equity market risk), but still have some active bets on a few stocks.
While diversification is the first risk reduction every investor should do it still exposes the portfolio to market risk. In case your outlook for equities turns a bit more negative due an energy shock, lower Chinese growth, higher recession risk, or some other thing, you can choose to reduce your market risk. In the next sections we will describe four different ways to reduce market risk.
Shorting futures or CFDs
The most simple way to reduce market risk is by shorting futures on a large equity index. For an European investor with many European stocks in the portfolio the STOXX 50 or STOXX 600 index futures are the natural choice. Most retail investors will find it difficult to calculate the beta of their portfolio, so the most simple heuristic is to think in exposure terms. The STOXX 50 Dec21 future (Saxo ticker is FESXZ1) has a contract value of 10 times the underlying index value, so that is around €39,625 in today’s session (STOXX 600 futures have a contract value of €22,270). If an investor has a portfolio of stocks worth €100,000 then shorting one futures contract on STOXX 50 would reduce the market exposure by 40% as the net exposure is now €100,000 - €39,625.
There are two issues with shorting futures for many retail investors. It costs financing because you by the futures contracts on margin, and secondly the contract size means that it is difficult to properly reduce risk in smaller steps. That’s why some use CFD index trackers (Saxo ticker is EU50.I for the STOXX 50 index) for shorting because their nominal size is smaller, but this convenience also comes with a higher cost on financing. The CFD index tracker on STOXX 50 allows the investor to should one times the underlying price and thus the nominal exposure is €3,963 or 1/10th of the futures contract.
The clear benefit of shorting with futures and CFDs is that they are what market professionals call delta one products meaning that they give instantaneously risk reduction because they track the underlying hence delta one.
Long put options
Options give investors the right, but not the obligation, to buy or sell an instrument at a certain price at a given point in the future. Options are like an insurance so investors pay a premium for this right. Investors can get instantaneously risk reduction on equities by buying put options (the right to sell the instrument at a specified price) at-the-money, meaning that the strike price is close to the underlying price.
Let’s say an investor is negative on equities until year-end. One could then buy a put option on the S&P 500 but these options have a contract size of 100 times the underlying so these contract values make put options on S&P 500 unreachable for many retail investors. But luckily we have very liquid ETFs on the S&P 500 index and other indices, and these ETFs also have a liquid options market. A put option on the popular SPDR S&P 500 ETF Trust (Saxo ticker is SPY:arcx) with expiration on 17 December with a strike price of 428 (the current pre-market price) costs $12.86 yesterday and likely more than $15 with the current futures price on S&P 500; this is a 3.5% premium which means that the market has to fall by more than 3.5% before the put option is in-the-money at expiration. The put option on this ETF has a multiplier of 100 which again means that the exposure on the put option is $42,800 which again is quite high for most retail investors.
A variant on buying put options at-the-money is buying them out-the-money, which means that the investor buys a put option with a strike price below the current underlying price. This makes sense for investors which 1) wants to pay a smaller premium, and 2) are willing to accept a further drawdown to a certain price X and then the investor wants to be hedged.
Long volatility using VIX futures or ETNs
A third option for hedging market exposure that has become popular in recent years is long VIX futures, which many retail investors do through ETNs that holds the underlying VIX futures. However, these products to not give the investor a linear risk reduction like equity index futures, as volatility tends to spike and then calm down, and during calm periods the ETN constantly roll into new long VIX futures as the old ones expire. Since the VIX futures curve is upward sloping, the ETN constantly buys long volatility exposure at a high price and then “rolls down” the curve to a lower price and realize a loss. This is why these strategies typically have a negative expected return (see chart below on the Lyxor ETF S&P 500 VIX Futures Enhanced Roll) interrupted by massive positive spikes when volatility explodes higher on sharp selloffs in equities.
From early 2018 until today the annualized return has been 2.8%, so this is your annualized premium to get tail-risk protection when things get ugly. During the early days of the pandemic the ETN gained 253% providing good protection against rapidly falling equity prices. The key thing to understand is that long volatility strategies give you unpredictable hedging unlike shorting equity index futures and they have a negative expected return.
Market makers have an unique risk profile
Shorting futures require timing skills and better than random predictions on market risk. Long put options or VIX futures both come with tail-hedging capabilities, but also negative expected returns. In two recent research notes Tail-hedging with market makers and Equity correction and tail-hedging with market makers, we explain some of the benefits of using publicly-listed market makers as hedging components. They typically have zero correlation to the global equity market and they do well during the most stressful days in equites because market makers are naturally long volatility and earns excess profits during excess volatility as they get paid a premium for providing liquidity to the market. But even more importantly market makers have a positive drift over time as volume in financial markets tend to rise over time. The only two publicly-listed pure market makers in the world are Virtu Financial (VIRT:xnas) and Flow Traders (FLOW:xams).
As with long volatility strategies using VIX futures, long market makers are not an exact science in terms of the degree of risk reduction because do not track the global equity market. Long market makers are suitable for investors only interested in hedging tail-risk scenario (large declines in equities).