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Advisors often overlook the value a hedged equity manager can inject into a portfolio, as recent outperformance of long only indices (S&P 500) has overridden other considerations. The case for hedged strategies, however, goes beyond relative returns.
That’s because hedged equity strategies mute the movement of equity markets, cutting off the extreme highs and – more importantly – the extreme lows. As a subset of the equity allocation in a well-rounded portfolio, hedged equity provides an underappreciated stabilizing factor – especially when volatility is elevated.
Hedged equity builds balance
A hedged equity allocation mitigates the kinds of emotionally charged decisions that cause investors to sell into market weakness. Herding behavior, as Robert Shiller documented in Irrational Exuberance, translates into ineffective and detrimental market timing, as individual investors extrapolate recent performance to infer long-term investment results at precisely the wrong times.
According to a Dalbar study of the returns that investors actually experienced in 2011, a notably volatile year in equity markets, “equity mutual fund investors gave up on the markets shortly before the year-end recovery and suffered a loss of 5.73%, compared to a 2.12% gain for the S&P 500. This eroded the long-term gains that began to recover from the devastating losses of 2008.”
Poor timing manifests itself in buying high and selling low based on prevailing sentiment, locking in losses when the magnitude of the drawdown in an equity allocation becomes too much to bear. But, when executed correctly, a hedged equity allocation manages that downside – and mitigates the undue stress that can cause such bad decisions.
Aside from the psychological and behavioral safeguards, there are mathematical benefits to the moderating drawdowns. A common miscalculation among individual investors is to believe that a 15% loss requires a 15% return to get back to “par,” but that underestimates the impact of lost capital.
For example, starting with $1,000,000 in the S&P 500 Index, let’s say an investor suffers a 15% loss during the first six months of the year. This brings the value of the investment down to $850,000. Earning 15% on that $850,000 during the remaining six months of the year brings the value of the investment back to only $977,500, a shortfall of $22,500. The return required to get back to the original amount of $1,000,000 is actually 17.65%. This mathematical phenomenon looms larger as drawdowns get deeper, as many investors learned firsthand after the massive selloffs of 2008 and early 2009.
A well-implemented hedged-equity allocation protects capital in down markets, resulting in a portfolio that can compound returns from a larger asset base when the market rebounds, putting the power of compounding interest more heavily in the investor’s favor.
