Objective: Reduce risks associated with bonds (duration, inflation, credit), increase return potential.
Traditionally, bonds have played two roles within a portfolio: generation of yield and protection of principal (used to offset or hedge against stock market volatility).
For over 3 decades, bonds have enjoyed a bull market as interest rates declined, and bond values rose. However, the monetary policy of ultra-low or even negative interest rates worldwide and massive liquidity injections into the financial system has eroded bond yields, hurting savers and those counting on the ‘income’ form bond yields. As such, savers are now forced to choose between yield or protection of principal—they cannot have both. For more on this, see here.
Against this backdrop, it’s no wonder many analysts and investment managers have a rather bearish outlook on bonds and pessimistic about the 60/40 portfolio (consisting of 60% stocks, 40% bonds).
As such, investors are increasingly seeking other options to provide some capital preservation within their portfolios. Hedged equity can serve as a surrogate to bonds to serve that role.
Consider the 60/40 portfolio.
Investors could take a portion of the portfolio invested in bonds and reallocate it to hedged equity. For example, 60% equities, 20% bonds, and 20% hedged equity.
Adding hedged equity in this way may allow you to increase exposure to equity markets in order to seek necessary returns, while mitigating portfolio risk and reducing exposure to risks associated with bonds.
Objective: Reduce overall portfolio volatility and drawdown risk.
For investors with a more aggressive, growth-orientation to their portfolio, hedged equity can help offset some overall risk while maintaining the ability to participate in potential equity market growth.
For example, having an aggressive portfolio investing 80% in stocks or equities and 20% bonds, hedged equity can help take some risk off the table.
To offset some of portfolio risk, you can take a portion of your equities and reallocate them to hedged equity. For example, your portfolio could be split as follow: 20% bonds, 60% equities, and 20% hedged equity. As a result, your portfolio may move less wildly up or down in relation to moves in the equity market (i.e. reduce the portfolio’s beta), while maintaining the potential to participate in market growth over time.
Objective: Re-enter equity markets (move cash off the sidelines) while mitigating risk.
Recent market events, such as the 2008 Global Financial Crisis or the Covid-19 Crisis, loom large on the minds of many investors. During and after such events, many investors are nervous about stocks and bonds and move some or even all of their money into cash. Often this means ‘selling low’ after big market losses and waiting too long to re-enter the markets, which can cost you over time.
While the risks inherent in investing are real, and the fear of big losses is understandable, to achieve long-term goals, and to outpace higher inflation, it is important to remain invested with a long-term view.
For those who are looking to re-invest large cash positions, hedged equity is a great way to ease back into the market without all of the risk. You could utilize 20% or more of your cash holdings to establish a hedged equity position for your portfolio to achieve market participation and risk mitigation.
