An article by Scot Billington, Covenant Capital Management

Unfortunately, most traditional hedges fail to deliver in several key areas.

Buy-and-hold investing has been wildly successful since 1982; however, its adherents have had to endure two 50% drawdowns, a 25% down day, and 14 years of zero return. Long-term wealth is significantly impacted by drawdowns of more than 25% because the necessary recovery rally follows an exponential curve. Let’s look at what’s needed for recovery:  A 30% decline requires a 43% rally to get back to even. A 40% decline requires 67%; down 50% requires +100; and down 60% requires a wealth devastating 150% return to get back to square.

As we sit on all-time highs, what can an investor do to minimize the damage of the inevitable yet unpredictable next downturn? As importantly, can they also do so while participating in the upside?

What would this “perfect” hedge look like?

  1. Minimize cost. The hedge improves portfolio downside performance more than it hurts upside performance.
  2. “Exponentiality.” The hedge’s profit and rate of profit increase as a market decline accelerates and deepens.
  3. Capital-friendly. Avoid opportunity cost of diverting equity market exposure to the hedge.

From simply keeping money in cash (which is not the worst idea) to complex bear funds, individuals use several strategies to hedge their market exposure. Regrettably, these strategies often fail the investor on many fronts. For example, the investor takes $100k out of equities and invests in a hedge. Then, the S&P rallies 20% (investor loses $20k in profits), and the hedge loses 15%. Rinse and repeat for three years. Now, the $100k is worth $61k instead of $172k. Finally, a bear market arrives, and the market drops 35% over the next eight months. So how did the hedge do? It made $6k. Hooray.

Most traditional hedges fall short because of four critical aspects:

  1. The first 10% – It only takes an 11% rally to recover from a 10% loss, so these declines have very little impact on long-term wealth creation. The first 10% is also EXTREMELY expensive to insure, much like a low deductible on an insurance policy. Very expensive protection forms a low-impact risk.
  2. Paying retail for insurance – When investors buy put options, they are not alone.
    1. Implied volatility > realized
    2. Volatility skew in index option markets
  3. Guessing – Many hedges depend on correctly predicting bear markets and selling equities to profit on these downturns.
  4. Lack of “Exponentiality” – Even long puts eventually lose their option components if the market drops low enough and the options are well in the money. The “exponentiality” of a long put flattens out as a decline deepens.

Investing is risky, and intuitively we understand that loss tolerance is required. Expecting to avoid all risks of losing money is unrealistic, but it doesn’t stop a large contingent from trying. This makes the first 10% expensive to offset, and the cost of doing so (losses on rallies) has a significant impact on long-term wealth generation. Currently, a one-year put option limiting losses to 10% costs about 5% of the portfolio. Therefore, every annual return is decreased by 5% to limit a single year’s loss to 15%. Much like the insurance industry, sellers of protection are more likely to come out ahead of the buyers in the long run.

This brings us to guessing. We often hear that timing the market does not work. However, even when investors guess right, they have been shown to underperform the market, according to Dalbar’s annual report titled Quantitative Analysis of Investor Behavior (QAIB). As stated in the QAIB report, asset classes often move together during a market correction, which necessitates a downside protection strategy that goes beyond traditional diversification.

To that point, the aforementioned aspects as to why hedges fail to explain why we began looking for better hedging in the first place. Fear and greed drive investor behavior and often yield sub-optimal decision-making. But if we could provide a better solution, perhaps investors would not panic during a drop and could maintain their buy-and-hold strategy, which has proven to work over long periods; and they wouldn’t have to rely on perfect timing.

Please look out for our next article, discussing our preferred solution and how we avoid guessing.