As market turmoil continues, we wanted to touch on the work being done here daily. Specifically as it relates to how we view and utilize hedging inside our strategies and portfolios. We can tell you, without a doubt, there’s never been more focus on carrying out our duties to the best of our ability for the benefit of our investors. Each day brings new challenges.
We are managing two distinctly different topics: The chance for more downside due to the uncertainty all over, and the awareness of what we believe to be the buying opportunity of a lifetime on the other side of this. Effective hedging can allow us to prepare for both….
The Bridge
Time is the bridge between potential and advantage. It’s what can transform a deliberate and immediate disadvantage into a massive future advantage.
We think about hedging portfolios through this lens. You don’t need to hedge…until you do. Most times, hedges are a waste of money. Sometimes, they are not.
The distance between “most” and “sometimes” is unknown…the bridge that spans that unknown must be constructed well. It must provide a structure for advantage to dwarf disadvantage when potential transforms. A hedge cannot impair participation in rising markets that offsets potential benefit in falling markets. If so, the purpose of the hedge is just marketing blabber rather than improved results.
You have to be excited and positioned to participate in rising markets. After all, up is the typical direction. Betting against that, especially over long time spans, is a losing bet.
If time is the bridge between the immediate disadvantage of a hedge and its potential advantage, we have to make sure the bridge is constructed well and able to carry the burden of your hard earned assets, no matter how long the span.
Why Hedge in the first place
Two reasons: Math and Behavior.
Our job is to build portfolios that investors can hold, even when poop hits the fan. Most investors miss out on returns (the behavior gap) because the path from point A to point B bucked them off at some point. Our portfolios are designed to deliver the ride of a Lexus, not a Wrangler. Will there be bumps…no question. But a smoother path can help reduce the gap between what our portfolios deliver and what our investors receive. That’s what matters.
In our opinion, the current market backdrop leaves you no choice but to hedge. There was more risk in stocks and bonds than we’d ever seen, and Covid-19 brought it all to the surface, quickly.
What happens when the correlation between stocks and bonds increases and the direction of prices is down everywhere you look? Thank goodness for hedges. Back to the math of it…
The S&P is down over 30% in one month. As you know, we manage three distinctly different hedged ETFs; to say they’ve done their job is an understatement. Besides helping advisors’ conversations and investors’ ability to cope with the current market environment, they’re providing holders an advantage…reduced downside capture stems from profits on hedges, which provide capital to deploy into potential lower valuations. Remember, deploying capital at lower valuations has historically meant better returns with lower risks moving forward, more on this in a second.
A strong relationship between upside/downside capture (meaning more upside participation and less downside participation) and effectiveness at reducing drawdown are two aspects that have made our returns more Lexus and less Wrangler. It’s a win for investors, and effective hedging gets the credit.
Drawdown reduction is a product of effective hedging, but it’s not the purpose of our approach, just a nice perk. Returns and the risk associated with those returns, are the only things that matter to us. Can we find sufficient return with acceptable risk? With that framework, hedges provide two distinct advantages:
#1 Improving Potential Returns at the Allocation Level
Asset allocation is the most important decision we make at the model level. Stocks or bonds. We’d argue, stocks offer higher future returns than bonds. In fact, and we won’t belabor the point we’ve made numerous times, we’d also argue bonds offer little to no returns moving forward.
Owning more stocks rather than bonds provides for higher potential returns at the portfolio level. Our hedges allow us to over allocate to stocks within our risk-based portfolios without adding in too much risk. Our hedges help chop off the left tail of unknown stock market events like this year has thrown at us.
We created our strategies for the overall model portfolios to help advisors overcome the allocation issues of today’s market. Their value has been apparent in 2020.
#2 Improving Potential Returns during Market Turmoil
Falling stock market prices are immediately painful. The hidden benefit is that with falling prices, future returns are increasing. That only matters to investors if you have the cash to deploy.
Our investors have been accumulating more stocks at cheaper prices with profits from our hedges. That’s by design. The flexibility that reducing drawdown provides allows us to take advantage of cheaper prices. As stocks fall, hedges rise. We take some of those profits and buy more hedges. We take the rest, and buy stocks at lower prices. More shares, more dividends, better upside…and we do it all under the hood of our ETFs.
Our hedges provide the ability to increase potential returns during market turmoil. While other investors are in a panic hoping for things to settle, we can methodically add at lower prices while our hedges continue to do their job. We cannot overstate the importance of this to help increase potential return and improve upside capture so we can begin climbing out of the hole (a much shallower hole to begin with) as quickly as possible.
It’s important to note, valuations may not have lowered. We know prices have dropped, but we don’t know how much earnings will. We do believe valuations have cheapened and that the other side of this mess will become apparent quicker than most believe. We want to make sure we are prepared for that, and adding as prices drop is a great way to help.
In Closing – The Greatest Hedge of All
The near term results of Covid-19’s impact on our economy will almost inevitably be ugly. We’re afraid it will get worse before it gets better, but hopeful you can find comfort in knowing that our use of hedging has dramatically reduced our exposure to falling prices and created capital for deployment at lower prices.
We have two additional facts to help ease the discomfort of headlines today, and maybe tomorrow:
First, our positioning at the fund and strategy level has never been better positioned towards limiting downside capture. If markets fall further from here, you will feel even less than you have up to this point.
Secondly, and most importantly, stock market risk is transformed by your time horizon. The longer your horizon, the lower your risk. Longer horizons are a hedge by themselves and the great news, your horizon is most likely longer than you think. This is true whether you’re 30 or 70. Remember, stocks usually go up. Despite short -term bouts of craziness, stocks are as good as it gets when it comes to compounding hard-earned capital.
Time is your trump card over near-term uncertainty and volatility. Across the country, investors are going to open their March statements and forfeit that trump card by going to cash. But good investing is done through the windshield not the rear-view mirror. For those with a solid foundation, a move to cash now simply swaps near-term volatility risk for long-term longevity risk. That’s not worth the trade off at this point.
We believe it may get worse before it gets better and containing Covid-19 should be the top priority across the globe. While we recognize that, it’s also important to recognize the massive stimulus coming out of Washington, the swiftness of this decline, and the amount of resources and energy devoted towards preparing and finding a vaccine. We’re long our ability to get through this and believe the current crisis could turn into the buying opportunity of a lifetime. Effective hedging has put us in a great position to take advantage of that.
Be on the lookout for model updates in the next week, both on the funds and the individual equities in the High Net Worth models. Rebalance rationales will accompany those updates, and we plan to complete those trades by month-end.
As always, thank you for your trust and please get yourself signed up at our new Content Hub where we’ll be adding new white papers and placing all of our updates. We’re also scheduling investment committee reviews and client outreach calls for the next 3 weeks, so please take us up on both if you’d like the help.
Be safe,
The Aptus Team
251.517.7198
This commentary offers generalized research, not personalized investment advice. It is for informational purposes only and does not constitute a complete description of our investment services or performance. Nothing in this commentary should be interpreted to state or imply that past results are an indication of future investment returns. All investments involve risk and unless otherwise stated, are not guaranteed. Be sure to consult with an investment & tax professional before implementing any investment strategy.
The Impact Series Benchmarks are the iShares Core Allocation ETFs. iShares Core Asset Allocation ETFs are designed as diversified core portfolios based on the specific risk consideration of the investor. Each iShares Core Allocation Fund offers exposure to US stock, international stock, and bond at fixed weights and holds an underlying portfolio of iShares Core Funds. Investors choose the portfolio that aligns with their specific risk consideration. iShares Core Allocation ETFs offer investments to meet a Conservative (iShares Core Conservative Allocation ETF), Moderate (iShares Core Moderate Allocation ETF), Growth (iShares Core Growth Allocation ETF), and Aggressive (iShares Core Aggressive Allocation ETF). Source: Blackrock. The volatility (standard deviation) of the Impact Series may be greater than that of the benchmark.
*The Impact Series claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. The Impact Series has been independently verified for the periods January 1, 2017 through December 31, 2018. The verification report is available upon request by calling (251) 517-7198. Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm’s policies and procedures are designed to calculate and present performance in compliance with the GIPS standards.
Investing involves risk. Principal loss is possible. Investing in ETFs is subject to additional risks that do not apply to conventional mutual funds, including the risks that the market price of the shares may trade at a discount to its net asset value (NAV), an active secondary market may not develop or be maintained, or trading may be halted by the exchange in which they trade, which may impact a fund’s ability to sell its shares. Shares of any ETF are bought and sold at Market Price (not NAV) and are not individually redeemed from the fund. Brokerage commissions will reduce returns. Market returns are based on the midpoint of the bid/ask spread at 4:00pm Eastern Time (when NAV is normally determined for most ETFs), and do not represent the returns you would receive if you traded shares at other times. Diversification is not a guarantee of performance and may not protect against loss of investment principal. ACA-20-67.
