Would You Cancel Your Car Insurance Just Because……….?

by | Jan 10, 2018 | Hedging, VIX, Volatility

Source: Wall Street Journal & Factset

2018 has opened the year higher amidst further low volatility and little fear in the markets. 2017 saw so little fear that the VIX Index closed below 10.00 over 50 times! The graph above, part of a recent Wall Street Journal article by Gunjan Banerji illustrates just how un-fearful investors have been over the past year. Statistically, 2017 would be considered a fairly large outlier event compared to previous years.

In the article there were a couple of main themes or attitudes Banerji uncovered:

  • Investors are determining hedging is a waste of money
  • Rather than hedge, buy market declines
  • Hedging eats into returns
  • Demand for protection is low

The attitudes outlined within the article actual are interesting from a couple different viewpoints. First, it is not surprising that “recent bias” has caused investors to forget about the risk of the downside as markets have moved higher. Thinking back to the post Great Recession period in mid-2009, many investors I spoke to opted to sit in cash for fear of another crash. The difference being their immediate memory only remembered the tough 2008-09 period.

At ZEGA, two of our core strategy offerings involve being long but hedged, or being long with a buffered downside. In the former the idea is to capture most of the good (upside) but illuminate most of the bad (downside). In the latter, the target is to produce returns in excess of market returns, have a buffer zone, while shifting the risk profile to more of a short term fixed income variety.

Getting back to some of the sentiments outlined in the article, the idea that hedges are a waste of money missed the point that the reason they were there in the first place was to allow someone to enter the market with protection. Many hedged strategies were never designed to match the upside move of a market. The idea that hedging eats into returns is another way of saying that a good hedging strategy may reduce upside gains. Yet remember the tradeoff is usually eliminating a good degree of the downside.

Buying market declines may also be a foolhardy approach. One, if someone is fully invested that would imply them timing the market perfectly by getting out at the top and then re-entering at the bottom. Most understand that is incredibly difficult to execute.

The fourth point from the list above is that demand for protection is very low. A contrarian might take this as a signal that the market is near a top since the contrarian view is the self-directed investor crowd is usually wrong. For the record I am not saying the market is or is not at a top. But you would think those with large embedded market gains or entering the market with new money would be more apt to utilize some downside protection. Especially considering how cheap relative to historical levels it currently is.

When we think about investors not being worried about the downside and throwing their risk management strategies out the window, I think a great analogy was found in the comments section of the Wall Street Journal piece:

    This is like letting your auto insurance lapse because you haven’t had an accident in ten years.

Douglas S- WSJ Online Comments Section

This comment really helps frame the decision to not worry about protecting the downside and explains my title choice for the article.

The good news is that if you are an advisor who would like to protect client assets as the market makes new highs or put new money into the market ZEGA has several solutions for you. Give us a call so we can walk you through it.

Later this week I will work some of the historically now VIX Index readings into our HIPOS weekly update to frame how the strategy has been doing relative to this environment.

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