Consider a rock climber, seeking to consistently reach higher, but inserting pitons for safety into the rocks in case they suffer a misstep or a fall. Within investing, a hedged equity strategy may perform the same function – allowing investors to grow with the equity markets but may provide extra security when it’s needed.
TIFIN Personality spoke to Swan Global Investments to learn more about why now may be the time to consider a hedged equity strategy, which aligns with the Security financial personality type.
TIFIN Personality: The 40-year bond bull market has come to an end. How does a hedged equity strategy provide a potential alternative for bonds?
Swan: It’s no secret that there’s been a sharp decline in bond values driven by the rise in interest rates this year to combat inflation. Bond yields and interest rates move in the opposite direction of prices.
Modern portfolio theory advocates for a mix of non-correlated securities and diversification to mitigate risk. Bonds, of course, have historically served the dual roles of preservation of capital and income. But considering the rising rate and persistently inflationary environment, investors are seeking an alternative to bonds. Swan’s approach to hedged equity is that we passively invest in low-cost equity index ETFs and use long-term put options that are inversely correlated to the underlying equities in order to mitigate equity losses when they occur. That provides what we consider true diversification. While it’s true that market risk cannot be eliminated through diversification, it can be hedged. That’s our specialty. We believe the risk mitigation provided by hedging can serve the capital preservation role bonds historically provided, without all of the risks inherent in bonds.
TIFIN Personality: So, the protection or hedge comes from the put option?
Swan: Correct, that’s why we see it as a solid alternative to bonds. A put option is a contract giving the option buyer the right, but not the obligation, to sell a specified amount of an underlying security at a predetermined price within a specified time frame. A put option is inversely correlated to the underlying investment.
A put option becomes very valuable during a market off, as investors look to buy protective puts. Through our active risk management approach, we seek to capitalize on hedge appreciation in market downturns – selling that hedge that has become highly valuable (sell high), buy an additional long-term put hedge, and with the remaining proceeds seek to buy more shares of underlying equity ETF (buy low). This process seeks to help investors mitigate risks and navigate major market downturns.
TIFIN Personality: Do you see a shift away from bonds underway?
Swan: Yes. It’s slow and steady, however. For generations, bonds have been a great place to invest, providing protection with some income along the way. It’s hard for investors to change their minds regarding an investment that has worked for so long and to jettison to something they are not familiar with. And for many, options are misunderstood or mistrusted. But the reality is the concept of hedging has been around a very long time and many industries utilize hedges. Airlines, farmers, banks, industrial companies hedge to manage input costs or the cost of fuel – the list goes on.
The interest in options has been growing over the past couple of years as investors seek alternatives to bonds, with options trading hitting an all-time record last year. Morningstar’s Options-Trading category is one their fastest-growing categories in terms of number of funds and assets. It is important however to note, like any investment, there are inherent risks for individual investors who do not understand the concepts or impact of volatility and other market forces on options movement and pricing if they try to execute their own hedging strategy. So, it may make sense to work with professional investment firms who manage options-based or hedging strategies in mutual fund and ETF format.
TIFIN Personality: So, is the 60/40 portfolio is officially dead?
Swan: As we see it, yes. The extended period of stimulative monetary policy, plus the massive fiscal stimulus over the past couple of years has driven down bond yields and driven up risk asset values. Investors now face the prospect of bonds and stocks falling in tandem – a dual dilemma. Add inflation, volatility, supply chain issues, geopolitical risks and everything else going on in the world, hedging remains imperative.
TIFIN Personality: What would you say to an investor who may be overwhelmed by the current market turbulence?
Swan: Just because the stimulative “party” is over, does not mean you have to be deflated. Investors need to reassess as we go through the economic cycle. Inflation really hurts bonds and persistently high inflation often hurts stocks, so we see a hedged equity strategy as the happy medium. You don’t want to think everything is getting worse and not participate in the return potential of stocks or be too optimistic and not manage risk of major declines. When investors have a smoother investment experience – fewer severe lows while giving up some of the extreme highs, they’re more likely to stay invested, avoid emotional reactions and improve long-term outcomes. When your core asset is equities, as in our strategy, it’s comforting to remember that it’s been the better performing asset class over time. So, we have reason to think it’s all going to work out if investors stay the course.
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Swan Global Investors provides compensation to TIFIN Grow, LLC or one its affiliates to be a sponsored fund which provides the fund greater visibility. TIFIN Grow, LLC has a financial interest to promote and market investment solutions from Swan Global Investors that can conflict with the interests of its clients. This material is provided for informational purposes only and should not be construed as individualized investment advice or an offer or solicitation to buy or sell securities tailored to your needs.