This bull market is ageing, and as with everything else that ages, wrinkles are starting to appear. The bull market could gradually fade away or it could stumble and fall. Either way, investors have to start thinking about how they can handle the regime shift.
Laying the groundwork
Downside protection tools can assist in mitigating certain portfolio risks. But before even considering the appropriate tool it is important to understand what risk is and how exactly risk mitigation and hedging differ. In addition, costs, timing, and expertise all play a crucial role in selecting which tool(s) to use and how to implement them. Using the right tool at the wrong time can mean that a portfolio is protected but still does not perform as expected.
What does risk mean?
To appreciate the specific risks of a portfolio, it is essential to know exactly how the portfolio is positioned. What are its market, sector and stock exposures?
But downside risk can take many flavours, such as:
- Event risk - hedging a specific event such as a sovereign default or a war in the Middle East.
- Protecting against regional, sectoral and company risks, as well as currency exposure. For example, a portfolio concentrated in US stocks is exposed to the country’s political landscape, trade balance, high technology sector weighting and fluctuations in the US dollar against the investor’s domestic currency.
- Benchmark risk - biases at a factor or sector level versus the benchmark. A portfolio represents a manager’s core investment beliefs but factors or sector weights can diverge from the benchmark, introducing a source of risk. For example, if a portfolio is underweight financials relative to the benchmark, an investor may seek ways to increase the exposure to financials to more accurately reflect the markets’ characteristics.
Hedging versus risk mitigation
Downside protection can be thought of as hedging and/or risk mitigation. The two are similar, and there are areas of overlap, but they are not the same.
Hedging strategies are specific, targeted, typically time-bound, and require technical skill, whereas risk mitigation techniques are more general in nature rather than specific, require less technical skill to implement, and are typically thought of as longer-term solutions to risk.
To be more exact, good hedging should meet all the following conditions:
- It should be regionally congruent to the portfolio and correlated to it. So it should be directly relevant geographically and sectorally, otherwise it becomes an unrelated short position rather than a hedge.
- It should reduce a negative effect, rather than be intended to add a positive gain; otherwise it becomes an active bet.
- It should be reflective of benchmark risks; otherwise it will not work as a hedge for the portfolio.
- The protection provided needs to be genuine and specific, not a vague protection which risks failing in its objective.
Keeping a lid on costs
Costs are a crucial consideration in choosing the protection tool. Timing - choosing when to act - and deciding the proportion of the portfolio to protect, contribute to the charges for protection. Systematic hedging without regard for timing or portfolio structure is generally an expensive strategy and can end up detracting more from portfolio return than from the risk it is intended to protect against.
Given that it’s notoriously difficult to time market downturns perfectly, the chances are that investors implement a hedge too early. Maintaining it could require repeatedly renewing the hedge instrument, leading to mounting costs. A way to reduce these costs is to wait for catalysts which trigger the sequence of events that eventually lead to the downside effect. When these catalytic events occur it’s possible to react quickly and place a hedge which can protect against much of the downside at a reasonable cost.
The other key consideration is selecting how much of the portfolio to hedge. It can be prohibitively expensive to protect the whole portfolio so a decision needs to be made as to which securities it makes most sense to protect. This boils down to a cost/benefit calculation.
Choose your weapon
There are seven main categories of risk mitigation and hedging tools.
- Security selection
- Asset allocation and tactical shifts
- Non-linear derivatives
- Delta one hedging
- Dynamic hedging
There is no ‘one size fits all’ downside protection tool and each approach has its pros and cons. The investor must carefully analyse their portfolio, the risks involved, and the characteristic of each tool to decide which tool(s) to use and to what extent. However, we think that the first two risk mitigation tools (security selection and diversification) should be almost universally employed because of their comprehensive benefits for investors.
Investors most fundamentally need to have a clear understanding of what their investment objectives are and how their portfolio is constructed to manage downside risk. There are many protective tools at their disposal but picking the right one, or combination, requires thoughtful analysis and regular adjustment.