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Summary

  • Valuation is the least reliable of the three drivers for timing a hedge.
  • When hedging event risk, investors often fall prey to two behavioral biases that can hurt performance.
  • Using fundamentals as a guide for hedging poses two problems.

By Ted Samulowitz

Hedging a portfolio to mitigate risk can have a downside - hedge too early, and the portfolio misses further gains; delay, and losses are locked in. Yet many investors engage in spur-of-the-moment hedging based on emotion rather than relying on a process. Here, I discuss three basic drivers of market downturns and portfolio damage control for investors to consider as part of their hedging process. These themes are sophisticated and complex, and I'm providing them for educational purposes only - not as investment advice. Investors should always discuss investment ideas with their financial advisor before making a decision.

Downturn driver 1: Valuation

Because valuation is based on growth expectations and assumptions about interest rates, it's subjective and subject to large changes from small variations in either factor. Common valuation metrics include the market-forward-price-to-earnings ratio, market-price-to-earnings ratio and price-to-sales ratio. While some metrics may be more useful than others, valuation is the least reliable of the three drivers for timing a hedge. Why? Because all common valuation ratios have at some point indicated the market was overvalued - just before the market rallied far beyond its "overvalued" levels.

Downturn driver 2: Event risk

Event risk - the 9/11 terrorist attacks and Enron's failure, for example - is tricky to navigate when hedging a portfolio because investors often fall prey to the two behavioral biases that can hurt performance.

  • The "recency effect" occurs when investors are overly influenced by recent events versus those further in the past. Case in point: Because of volatility in 2001, 2008, 2010 and 2011, many investors today consider it normal, while many investors during 1980s and 1990s thought that the bull market was normal.
  • The "empathy gap" occurs when investors underestimate the effects of emotions on their decisions, which can result in following the crowd rather than a disciplined process.

Downturn driver 3: Fundamentals

Fundamentals gauge the economy's health, while the stock market is an imperfect guide to the economy's value. Using fundamentals as a guide for hedging poses two issues:

  • Fundamentals don't have to be bad for stocks to go down. A recent example: As the economy was healing during 2010 and 2011, the stock market experienced volatile contractions.
  • Fundamental data can lag market moves - both near market tops and during market bottoms - and also undergo heavy revision, so today's numbers may look nothing like revised numbers.

Putting it all together

Major market contractions don't happen in a vacuum; they usually result from a combination of unfolding factors. So how can investors hedge effectively against risk but also give themselves room to get the timing wrong? Minus a crystal ball, I believe the best place to start is to put a process in place to potentially minimize the damage from a financial storm. These guidelines can serve as a starting point for discussion with your financial advisor:

  • Fundamental breakdowns, in my view, have higher potential to cause a drawn-out contraction, so a willingness to hedge more aggressively in these times may be necessary.
  • Event risk tends to have lower probability than we expect, so the hedging vehicle chosen should be flexible and potentially lower in cost.
  • High valuations can persist, but if they are accompanied by event risk or fundamental weakness, the level of aggressiveness in hedging should increase from rotating sectors to possibly exiting equity exposure.

The market evolves with new information every day. Before acting on that information, it's important to understand how it fits into your long-term plan and process and to discuss potential effects of changes with your advisor.

Read Hedging Your Equity Portfolio Risk: Three Drivers to Consider for a more comprehensive discussion of this topic.

Important information

Market-forward-price-to-earnings ratio: This ratio takes the current market price and divides it by analyst expectations of where earnings will be one year from now.

Market-price-to-earnings ratio: This ratio looks at current market price and divides it by the current earnings on the index.

Price-to-sales ratio: This ratio is defined as the market price per share divided by revenue per share.

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The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. The opinions expressed are those of the author(s), are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

All data provided by Invesco unless otherwise noted.

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Source: Downturn Savvy: Getting A Handle On Hedging