Stock Market Hedges Aren't Created Equal

By Jim Picerno, Director of Analytics

The coronavirus crisis has refocused attention on hedging, including stock market risk. The question, as always: Which hedge to use? There are numerous possibilities but no universally accepted methodology. No surprise, of course, since every hedge is unique, depending on current market conditions, expectations, the price of the hedge, and other factors.

As an initial screen for deciding how to choose, analysis by Kai Wu, writing for Verdad Capital, recently posted a useful guide that compares the Sharpe ratio of various hedges (a proxy for cost) relative to the quality of the hedge via the correlation with the S&P 500 Index. The main takeaway: there’s a strong link between quality and price. As in other venues, you tend to get what you pay for.

The ideal combination, of course, is low cost and high quality (the upper left-hand corner of the chart below). Unfortunately, perfection doesn’t exist and so there’s a tradeoff between cost and quality. For example, a long position in the VIX Index (a forward estimate of stock market volatility) scores strongly as a quality hedge (deeply negative correlation with S&P 500) but it’s relatively expensive.

By contrast, Treasuries are inexpensive but the hedging quality is middling, at least in terms of correlation with the S&P 500 through time. But sometimes even a modest hedge is enough when the stock market takes a dive, as we’re reminded via strong returns in government bonds this year.

When market risk seems unusually high, the Milwaukee Company may recommend clients invest in stock option contracts to protect against falling stock prices. For example, a put option allows the holder to sell a covered security at a stated price within a specified time frame, thereby limiting downside risk.

Is factor-based investing still relevant?

It is a well-accepted premise that the bulk of stock market returns are driven by certain measurable characteristics known as “risk factors” (or simply “factors”). Examples include quality, value, momentum, size, and liquidity, to name just a few.

What’s the case for dividing equity holdings into multiple factor slices? In a word: diversification. The slightly longer answer: no one knows which factor risk premiums will lead and lag in the future and so by spreading your risk you’ll avoid the worst mistakes that weigh on the most aggressive strategies at times.

A naïve view looks at what’s worked best in the recent past and assumes that history will continue. Sometimes that’s true, but unless you’re highly confident about how the future will unfold (and willing to pay a relatively heavy price if you’re wrong), diversifying across risk factors within an asset bucket is a prudent plan.

As a simple example, consider how the large-cap equity growth factor has fared vs. its small caps and foreign-equity value counterparts via a set of ETF proxies. The iShares S&P 500 Growth ETF (SPY), which tracks US large-cap growth shares, has surged 10.3% on an annualized total return basis over the past five years (through June 3). The comparable returns for US small-cap (IJR) and foreign value stocks (VEU): a relatively modest 4.8% and 2.1%, respectively.

Investors willing and able to tolerate a high-risk strategy may be willing to stick with U.S. large-cap growth to represent most or even all of equity exposure in a portfolio. But for everyone else the question is whether a richly valued corner of equities will continue to deliver stellar results? If you’re not sure, diversifying across equity factors is a compelling antidote to an uncertain future.

Will mutual funds convert into ETFs?

The ETF business reached another milestone recently with a proposal to convert two Asia-focused equity mutual funds (MFs) into exchange-traded funds (ETFs). Although the SEC has yet to approve the conversion, industry observers expect the proposal will receive the green light.

Given the various challenges that have been weighing on open-end MFs in recent years, an SEC approval may open the floodgates in a rush to convert. If so, the main beneficiaries: investors. Given the advantages of ETFs over MFs (lower costs generally and greater tax efficiency, for example), it’s easy to imagine that many beleaguered open-end products will look to convert to ETFs.

Will the conversions succeed? Some will, but certainly not all, as the markets are awash in under-performing MFs charging too much money for mediocre (or worse) results.

For the discerning investor, however, a greater array of ETF options is a good thing. There are, after all, some solid MFs out there, even if they are the exception to the rule.

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