Does Hedging Eliminate Bubble Risk in Markets?

by | Apr 6, 2017 | Buy & Hedge, Hedging, Technical Analysis

Investment bubbles have taken on mythical status among the investment community. Whether it’s the South Sea Company (pictured above), Tulip Bubble, Tech Bubble, or Housing Bubble they provide fascinating case studies on behaviors in finance.

Recently we touched on how advisors can use hedging to reduce fear by investors worried about buying into markets at all-time highs. (Click here to view) That article spurred some further conversations with advisors around why some are reticent to implement a disciplined cost effective hedging strategy. Often, we hear that hedging is expensive and cuts into profits when underlying investments move higher. Fair enough, yet as we’ve outlined, clients using our hedge equity strategies still capture most of the upside, historically. At the same time, we build portfolios with hard floors that can cut much of the worst part of the downside moves.

Other common objection is the notion that over the long run, markets recover and clients should just ride it out. Another fair point, but while markets over nearly 100 years have shown the ability to come back and produce a nice annualized return, many of your clients have windows of opportunity to grow their assets. A catastrophic decline during a ten-year period could make it tough if not impossible to re-grow their assets to a point that would support their retirement lifestyle goals. This of course depends on how close to retirement the client is.

One advisor asked the question that provided the basis for this article: If the account is hedged, would it matter if you invested at the top of a bubble? Looking at our graph above of the South Sea Company we can see this was a historic bubble. From the end of 1719 to mid-1720 the price rose from around 150 pounds to nearly 1000 pounds. So, what if one bought in at 800 near the absolute top but were hedged with a 10% downside floor built in? Well, as price corrected and collapsed losses would be abated below the floor. If instead price had gone to 2000 the investor would have participated in most that upside move as well.

ZEGA was not around back in the early 1700’s, obviously. Beyond this price chart, there is no way to estimate what the cost of hedging might have been. The point of the article is to think about how to reduce concerns about timing entries. Many clients think the market is over-priced when it is near all time highs. And many clients miss the continuing Bull market as a result. Over the long term, understanding how to reduce the cost of hedging is a major part of our efforts for your clients.

Want to see how our Buy and Hedge Retirement and Buy and Hedge Classic models faired during various market periods? Take a look here.