Hedging and other strategies to prepare for market volatility

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Stock and bond prices are at record heights. So is the ownership of stocks. Moreover, core inflation rates are at their highest readings since 1987 in Canada and 1991 in the United States, and central banks are beginning to talk about taking the punch bowl away. Lastly, flows into funds, along with IPO and merger activity, are at levels characteristic of market tops.

Maybe it’s a good time to look into some hedging and market-neutral strategies for investment portfolios?

Most money managers that serve high-net-worth clients know how to implement hedging and market-neutral techniques. They can use them to smooth portfolio volatility and ease investor anxiety in the event market fluctuations become severe.

Skilled practitioners have even used these methods to generate positive returns in bear markets. Indeed, Warren Buffett, the legendary chairman of Berkshire Hathaway Inc., attributes much of his superb track record to them.

Hedges

A classic hedge is to buy put options on an underlying security such as a stock or market index. Put options bestow the right to sell the underlying security at a given strike price prior to the option’s expiration date. If the stock or market index falls below the strike price, a gain will arise to offset the decline in the stock or portfolio.

However, put options typically expire without value since significant equity downturns are infrequent. So buying put options over time can get costly and become a significant drag on performance or even lead to abandoning the protection.

A way to eliminate the cost is with a zero-cost collar strategy, advises Richard Ho, a senior manager covering equity derivatives at the Montréal Exchange (MX). The cost of the put option is recouped by concurrently selling an out-of-the money call option with a premium equal to the one on the put.

“Most of the portfolio managers that I know at family offices tend to use this collar method instead of a plain vanilla put hedge,” adds Ho. “In fact, some use it to generate income by selling a call option with a longer expiration date to get a larger premium.”

Hedges can be put on in other ways. For example, currency risk can be minimized by using USX options, as explained in “Using USX options to hedge U.S. dollar risk” on the Montréal Exchange’s Options Matters site.

Futures contracts on stock-market indexes and other assets can also be sold short for hedging purposes (although the losses can be much greater than the capital put up). Even more esoteric and in the realm of professional management are the use of swaps – swapping cash flows in the foreign currency with domestic at a pre-determined rate.

Market-neutral approach – arbitrage

Market-neutral approaches are used by many hedge funds and professionals. One of the more notable variants is that of arbitrage, especially in the case of corporate mergers.

When mergers occur, the stock of a company to be acquired usually trades at a discount to the takeover price during the months waiting for regulatory approval, shareholder signoff and other requirements.

A merger-arbitrage specialist can often tell which proposed mergers will go through, so they will buy shares in the targeted companies to realize a profit when the price spread narrows on closing. The gains from each merger may be small but they can add up, are reasonably assured and independent of the direction of the stock market.

In his early years, Buffett parked cash in merger arbitrage situations as a substitute for treasury bills when stocks were richly valued. “This category produces more steady absolute profits than [undervalued stocks] do,” Buffett wrote in a 1964 letter to investment partners. “In years of market decline, it piles up a big edge for us.”

Another common arbitrage play these days involves special purpose acquisition companies (SPACs). They raise capital and list on a stock exchange at a unit price of $10 with a commitment to make an acquisition within two years or else investors’ capital will be returned with interest.

“SPAC arbitrage seeks to acquire units of a SPAC at or below its net asset value to generate a return through either an exit at a premium to net asset value once the SPAC announces a business combination or at the IPO price plus accrued interest before a deal vote or through liquidation of the SPAC,” notes Julian Klymochko, CEO of Accelerate Financial Technologies Inc.

There are many other opportunities for arbitrage – for example, convertible securities (essentially taking simultaneous long and short positions in a convertible security and its underlying stock).

Also, with the advent of computers and quantitative methods, there has been a rise in statistical arbitrage whereby bets are placed on securities reverting back to historical means or correlations.

Market-neutral approach – long-short portfolio

Another variant of the market-neutral approach uses short sales of securities to set up portfolios of long and short positions, effectively removing all or part of the market direction. The goal is generate positive returns in both bull and bear markets.

This strategy has not fared well during the bull market in place since the 2008 crash. It’s hard to avoid consistent losses on short selling when a rising sea floats all boats. But a return to more volatile markets could improve performance.

About the only kind of short selling that is working during the bull market is the one that focuses on exposing corporate fraud (instead of betting against overvaluation, poor fundamentals and so on). The fraud approach is mainly practised by activist short sellers in short-bias funds.

For an indication of how good performance has been, consider Carson Block’s Muddy Waters Capital fund. Since inception in 2016, it has posted double-digit gains each year, averaging “an annualized return of roughly 19 per cent [after fees],” reports Institutional Investor.

Other activist short sellers are doing well in exposing frauds, notably Nate Anderson at Hindenburg Research. Such funds could perhaps be added to a net long portfolio to nudge it toward market-neutral status. The funds have an ability to earn positive returns in bull markets, and their returns should only improve whenever bear markets arrive.

Though the VIX volatility index stands at under 20 today, suggesting low volatility risk currently, many market watchers are cautioning investors to have a strategy for potential upcoming unsettled markets.