Hedging to Maximize Returns

It’s probably safe to say that most investors consider hedging to be a volatility-reduction strategy. Which is why our response to the frequently asked question of “why do you hedge?”—that we do so because we believe it can help us both reduce drawdowns in our portfolio and maximize returns—has on more than one occasion been met with a puzzled look.

After all, the idea of utilizing hedges to maximize returns appears to run contrary to the commonly held belief that given a long enough time frame, the best way to invest is by always being fully invested.

To better understand why we believe hedging can help us maximize our returns, we first need to unpack two beliefs that are embedded within the idea that the best way for a long-term investor to position their portfolio is 100% long, 100% of the time. These beliefs may initially sound like an argument for not hedging; however, we believe that the opposite is actually true:

Timing the market is more a matter of luck than skill. This implies that hedging would be suboptimal if there was a way to shift the performance attribution away from luck toward skill; in other words, just hedge when you think you need to! But it doesn’t work that way.

We believe that our “steady hedging” approach enables us to accomplish the results we want, and we’re proud of what we accomplished during the life of the Pro newsletter service using this approach.

The stock market will increase in value over time as public companies in aggregate are ultimately able to react to whatever curveballs are thrown at them and create value for shareholders. Although it is true there has never been a 10-year period where the market hasn’t finished higher, it is also true that market corrections are inevitable.

In fact, over the past 25 years, we’ve had 12 declines of at least 10%. For investors who are consistently adding new capital to their portfolio to invest, taking advantage of these declines requires nothing more than continuing the status quo.

However, for an investor who doesn’t have the ability to add new capital to their portfolio, it’s much more difficult to take advantage of declines in the market. In fact, it is impossible to do so if they are fully invested and don’t time the market by selling stocks to raise cash before the decline occurs. This is where hedging comes into play. Properly and steadily implemented, hedging enables one to overcome this shortfall by providing a new source of capital to put to use during corrections and benefit disproportionally during an eventual recovery.

The caveat with hedging is that, like all aspects of investing, there are no free lunches. If you want a chance at maximizing returns while reducing draw-downs, you must make trade-offs. This can come in a variety of forms such as capping your upside, needing to repurchase shares at a loss if you short stocks that rise in price, or paying option premiums.

Were we to remain static in our approach to hedging—whether by way of constantly maintaining a given net-long exposure or only using a single approach to hedging—achieving all of our goals would likely be impossible. This is why the cornerstone of our approach to hedging is to both remain flexible and constantly seek out ways to improve and iterate on our current hedging strategy. We firmly believe that is the only way we stand a chance of having our cake and eating it, too, when it comes to hedging.

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—Jonathan (JP) Bennett, CFA

The content in this message is provided for informational purposes only, and should not be relied upon as recommendations or investment advice. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues.

It is not possible to hedge fully or perfectly against any risk, and hedging entails its own costs. The success of hedging strategies depends on your ability to correctly assess the degree of correlation between the performance of the instruments used in the hedging strategy and the performance of the investments in the portfolio being hedged. Since the characteristics of many securities change as markets change or time passes, the success of hedging strategies will also be subject to your ability to continually recalculate, readjust, and execute hedges in an efficient and timely manner. Also, unanticipated changes in interest rates, securities prices, and other factors may result in poorer overall performance of a portfolio than if you had not engaged in any such hedging transactions. Such hedging transactions may also limit the opportunity for gain if the value of the portfolio position should increase.