Hedging sounds like a smart thing to do. Who doesn’t want stock market upside with less downside?
This post analyzes the performance of popular hedges when stocks correct.
Treasury bonds (IEF) have been a reliable buffer during bear markets:
The graph below groups Treasury returns based on 3-month stock performance:
The tall grey bar shows that since 2000, bonds have been unusually strong when stocks have been weak.
One reason for this is the negative correlation between the two:
Bonds would likely offer less protection in the next downturn if correlations reverted to normal levels. Plus, low yields mean rates would have to approach zero for bond prices to provide the same boost they did in the past two recessions.
Continued low stock/bond correlation and negative rates could happen, but in my mind that’s betting on the improbable. My baseline expectation for bonds is that they’ll provide low single-digit returns during the next recession.
Gold (GLD) has historically been a solid crisis hedge…
… but with long periods of negative inflation-adjusted returns.
The tricky thing about gold (and most other assets) is that small allocations don’t really impact total portfolio performance.
Here’s the historical risk reduction of a 5% allocation to gold:
If you’re going to make a unique allocation, you have to do it in size. Small allocations don’t matter.
Trend following has done a good job of reducing drawdowns during extended corrections, but not during abrupt crashes like 1987.
The false positives of trend following make investors second guess the strategy when good times persist.
Trend investors feel smart during a crash and stupid during a bull market.
Puts on stock indices have an advantage over other hedges in that they’re directly tied to what you’re trying to hedge. Investors pay up for this luxury and puts are typically overpriced relative to the volatility that’s actually realized.
The graph below shows the result of 97.5% in an S&P 500 ETF (SPY) and rebalancing 2.5% into puts every quarter.
Option protection is reliable but costly. It will bleed an investor dry if their timing isn’t impeccable.
“Purchasing put options to hedge downside risk while maintaining upside participation may sound like it provides a more appealing risk exposure, but it is an exposure that is expected to provide little return.”Source: AQR
- Bonds might offer less protection going forward due to low starting yields and more normal stock/bond correlations.
- Gold helps in a crisis but can tread water during calm periods.
- Trend following mostly works but can’t avoid quick crashes.
- Puts are the most direct way to insure stock risk but earn abysmal full-cycle returns.
There’s always a bull market in talking about a bear market. The holy grail of stock upside without downside doesn’t exist because all hedging solutions are flawed in some way.
Reducing stock exposure is the only guaranteed way to lower stock risk. Stocks will inevitably crash again and investors will scramble for ways to reduce volatility. The time to prepare for a storm is before it happens.
Stocks are 1% from record highs. Now is a good time to get your stock exposure in check, form realistic expectations for what hedges can provide, and remember that there’s no free lunch when it comes to downside protection.
Disclosure: I am/we are long VTI,VGIT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The trend strategy for the 1999 to 2009 and since 2009 graphs invest in SPY if its 12-month total return momentum is positive. Returns have been zeroed out for out of market periods. The long-term trend drawdown graph uses the same 12-month model and is based on AQR's U.S. MKT return series in addition to the risk-free rate. All compound returns and max drawdown graphs and tables include dividend reinvestment and reflect fund expense ratios. All results are gross of transactions costs. Results shown are hypothetical, simulated, and are not an indicator of future results.
Movement Capital (MVMT Capital LLC) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Movement Capital is properly licensed or exempt from licensure. This article is solely for informational purposes. Investments involve risk and are not guaranteed. No advice may be rendered by Movement Capital unless a client agreement is in place.