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Everything You Think You Know About Hedging is Wrong

By Derek Moore

Common myths around portfolio protection often lead investors towards the path of hoping something works but later disappointed. 

Google “portfolio hedging” and you'll find no shortage of articles that have been reposted every year with the same information. Many do not provide a reduction in anxiety and stress for your clients. Or may not offer the protection they originally thought. 

Trained advisors understand the difference and below we'll help you help your clients with a few of them.

Myth #1: Diversification

  • Yes, diversification does reduce concentration risk
  • No, it does not fully insulate portfolios when there is a systemic market event
  • Consider the 2008-09 Great Recession Period or March 2020 Covid Crash where multiple sectors and countries all sold off.
  • Diversification often fails when you need it most

Myth #2: Stop Orders

  • Stop market orders triggered at or below a price do not guarantee a price in the case of a gap lower meaning your exit could be far lower
  • Stop limits don't guarantee an execution for the same reason
  • Stops are often placed at poorly designed levels leading to getting triggered at inopportune times
  • Once your stopped out, when do you get back in? This leads to #3

Myth #3: Market Timing

  • You would need to be right twice: on the entry and on the exit repeatedly
  • Many investors have missed out on large up moves waiting for pullbacks
  • Paraphrasing Peter Lynch "More money is lost by investors preparing for corrections than in corrections themselves"
  • Very few active fund managers beat the S&P 500 Index over time so why do you think you'll join the elite few that do?

Myth #4 Covered Calls Protect

  • While they can generate a profit, the premium received only results in a small nominal reduction in downside risk
  • Adjusting positions requires more skill than immediately evident
  • Limited upside capture foregoing some percentage of appreciation 

Myth #5 Fixed Income (Bonds)

  • The 60/40 Stock, Bond portfolio is a staple, but historical performance includes periods where interest rates and thus coupon payments were much higher
  • The interest rate risk, also called duration risk, is near all-time highs
  • Bill Gross has said interest rates would need to go substantially negative to match the 40-year bull run they've enjoyed since the early eighties

Hedging Solutions

  • Create real floors or buffers in portfolios, not hope something works
  • Hedges that also allow for a good percentage of the upside appreciation
  • Beyond just buying puts, modern portfolio hedges can combine synthetic positions that shape how and where risk is taken
  • Hedging can utilize notional value created by owning options that control but don't own the underlying assets. This can be a more efficient means of asset              allocation
  • Reduce or eliminate the need to market time
  • Provide opportunities to use the avoided losses or hedging profits to re-enter markets after a material decline
  • Reduce Stress and anxiety over your portfolio
  • A modernized hedging strategy can allow for greater equity exposure while materially reducing the downside.