The Cost and Benefits of Hedging

by | Oct 2, 2020 | Market Updates

Embrace the Cost of Hedging…with open arms!

We have been excited to write this month’s update.  Hedging to improve outcomes is the center of our business and approach to managing the money entrusted to us.  Typically, we discuss return and risk as they are connected at the hip.  Today, more of the focus is on risk.  Given the uncertainty over the short term, it is important to reiterate how we view and manage unknown outcomes.

To start, let us provide clarity around 2 things:

#1 – What is a Hedge?

A hedge is protection or defense against loss.  When we hedge portions of portfolios, our intent is to reduce risk overall.  No, we will not avoid risk, but believe we can reduce it. And we think that reduction has the potential to move mountains towards improving outcomes for investors.  How?  It can potentially increase our ability to do nothing during times of market stress.  Yes, you read that correctly.  Doing less is doing more – we will come back to this.

#2 – The Behavioral Hand We Have Been Dealt

Losses are more powerful than gains emotionally.  This is known as loss aversion – the tendency to prefer avoiding losses to acquiring gains.  This plays into the behavior gap for investors as the emotional toll of witnessing losses during market volatility can lead to knee jerk reactions that are detrimental to overall outcomes.

Maybe you are reading that and thinking it does not apply to you.  Well, maybe.  But you are either lying to yourself or rare.  Most of us are impacted by this characteristic whether we like or not.

Loss aversion is not something that can be educated away, it is ingrained in our DNA.  No amount of education about the long-term benefit of a certain investment can overcome the short-term emotional damage felt when that particular investment is getting its face ripped off.

We do our best to inform every advisor and investor on the how and why of our approach.  But we fully recognize that managing short-term risk goes far beyond any educational help.

In short, lose less money, don’t drawdown, we think that’s what matters to minimize behavioral issues that can bite investors in the butt.

Cost of Hedging

We own hedges via options on certain investments.  These options go up in value when prices go down.  Reducing risk is not free.  The cost typically manifests itself via lowered upside capture.

For example, let’s say you own $100 of stock ABC and choose to hedge away risk by buying the necessary option for a cost of $2.00.  You can expect to lower your upside participation by up to $2.00 vs owning the stock outright.  You paid for protection (the hedge) that was never needed if stock ABC rises.  Therefore, your overall return will lag the performance of owning stock ABC outright, without protection.

There is plenty of research into whether the cost of hedging is justified.  While some believe this is up for debate, our opinion should be clear.  Yes, we think the cost of hedging is justified.

Our Portfolios

Think about our portfolios and the relationship between risk and return.  We hedge in a way that can transform two things:

  • Overall Portfolio risk: lower the better
  • Allocation decisions: freedom to allocate more towards higher potential return areas

The goal is sufficient returns with minimal exposure to behavioral inefficiency.

Summary and The Real Risk

Knowing the inherent aversion to loss, we are constructing portfolios that explicitly recognize this.  We are less concerned about upside capture than we are about the emotions that come with large drawdowns.

When going from point A to point B, the ride along the way matters.  The smoother the better. The real risk we are aiming to manage is a detrimental reaction to volatility.

From our perspective, the failure to stay invested and tendency to focus on short-term horizons are threats to investor outcomes.  Brad wrote a great piece about this recently.  It illustrates the power of doing nothing and the importance of a longer-term perspective.

Hedging is how we try to address both threats.  We believe proper hedging produces an environment that improves the ability to stay invested and maintain a longer-term focus. Ultimately, we think this should facilitate higher returns for investors.

As always, thank you for your trust.  Please don’t hesitate to reach out.

 

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward-looking statements cannot be guaranteed.

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 and tax professional before implementing any investment strategy.

Aptus Capital Advisors, LLC is a Registered Investment Advisor (RIA) registered with the Securities and Exchange Commission and is headquartered in Fairhope, Alabama. Registration does not imply a certain level of skill or training. More information about the advisor, and its investment strategies and objectives, is included in the firm’s Form ADV Part 2, which can be obtained, at no charge, by calling (251) 517-7198. The Funds are distributed by Quasar Distributors LLC, which is not affiliated with Aptus Capital Advisors, LLC. The information provided is not intended for trading purposes and should not be considered investment advice. Please carefully read the prospectus before making an investment decision. ACA-2009-25.

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