In This Volatile Time, Here’s How We’re Seeking to Hedge Equity Risk

As markets surged for the better part of the last two years, hedged equity strategies haven’t had many opportunities to demonstrate their value in protecting on the downside. But with volatility back in the spotlight, we wanted to share how our approach to hedging risk in our client portfolios. In a word: flexibly.

Managers of many long/short strategies may claim that their short books provide an effective equity hedge, as gains from the short positions can offset losses in a long portfolio when the market falls. As we have written in previous papers and blogs, we believe asset managers need a far more flexible approach to hedging equity risk. Some markets are simply not conducive to shorting. In those environments, portfolio managers need other methods to preserve capital and try to ensure that they don’t have to sell their best long positions to meet margin requirements when markets rebound.

Currently, we’re seeking to hedge our portfolio risk in a few ways. In recent years, we had used long duration U.S. Treasuries and Eurodollar futures as a relatively inexpensive and liquid hedge that proved useful when markets turned down at the onset of the pandemic and central banks enacted supportive monetary policy to buoy a fragile economy.

But given inflationary pressures and the potential tightening of monetary policy, that approach is now less effective. Since the markets for U.S Treasuries and Eurodollar futures are large and liquid, we were able to rotate out of those positions and use new hedges. Those include:

Put Spreads: Before the market was volatile and the cost of options increased, we used put option spreads to protect against market losses. Those are still in place.

Targeted Shorting: We have maintained a basket of short trades but are treading carefully in the event of a rebound, which would not be surprising with some indices near correction territory at the end of January. We are currently limiting our short positions to individual technology and biotechnology companies we believe are the most interest rate-sensitive because they aren’t profitable and don’t have positive free cashflow. A number of our current short positions are in companies we believe will require additional funding down the road.

Importantly, at this time we are generally not shorting the stocks of larger, established technology and health care companies that traded down during the selloff and whose valuations are now in “growth at reasonable price” (GARP) territory. In our view, many of these stocks will likely be among the first to rebound as selective investors buy them when markets dip.

Increased Cash Position: It’s a simple approach, but one we believe can be effective, particularly in today’s market. Over the long-term, we are bullish on equities and want dry powder to participate in a rebound.

Importantly, we are not now generally using cash to try to take advantage of intraday volatility. Such trading is risky, and tax inefficient for our shareholders. But we like the idea of having more dry powder on hand to deploy when opportunity presents.

 

In short, we believe any rally off the bottom provides an opportunity to seek to outperform both our benchmark and competitors. We want to remain liquid to be better positioned to take advantage of this kind of opportunity when it arises.

 

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