A Gentle Introduction to Hedging

What? Why? Who?

What is Hedging?

Here are a couple of popular definitions and explanations to get the conversation started:

Investopedia: A hedge is an investment that is made with the intention of reducing the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting or opposite position in a related security.

Varsity: Hedging makes sense as it virtually insulates the position in the market and is therefore indifferent to what really happens in the market. It is like taking vaccine shot against a virus. Hence when the trader hedges he can be rest assured the adverse movement in the market will not affect his position.


The way it is commonly described, hedging is the act of taking offsetting positions against a portfolio to even out the bumps in the market.

The CAPM β

According to EMH, a portfolio’s return could be fully explained by the market (source):

r = rfß(rm – rf) + α

Where:

  • = Expected rate of return

  • rf = Risk-free rate

  • ß= Beta

  • (rm – rf)= Market risk premium

If you set the risk-free rate (rf) to zero, you get r =  ß*rm + α

Now, subtract away the market from the asset returns and you’ll be left with α.

Basically, a perfectly hedged portfolio will be a completely market neutral portfolio who’s returns will be pure alpha.

The offsetting positions can be taken via futures or options. To keep it simple, we will use futures to illustrate an example.

An Example

It is 2005 and the master analyst that you are, you expect HDFCBANK and KOTAKBANK to be decades long compounders. So, you setup an equal weighted portfolio that has only those two stocks.

If you stayed with this portfolio, then you truly have 💎🤲

Even though the annualized returns during the ~15 year period is twice that of NIFTY 50’s, very few investors would have stuck through the 70% drawdown that the portfolio had in 2008 and the 40% drawdown it had in 2020. Not to mention the numerous 20% dips along the way.

The question that hedging tries to answer is as timeless as time itself: Can I have my cake and eat it too? Is there a way to get only the excess returns without the market’s ups and downs?

What is the “market?”

Given that your portfolio consists entirely of banks, what exactly is your “market?” The answer to this question is not trivial.

You could go with the NIFTY 50 index but it has companies from different sectors like oil, metals, IT, etc. How much of an offset do you expect it to provide?

Or, you could go with the NIFTY BANK index. Intuitively, you would expect it to be a better hedge because it is composed almost entirely of banks – just like your portfolio.

Rolling βs

Rolling βs of the portfolio to each index gives us an idea of the appropriate benchmark to use.

What this is telling us, with perfect hindsight, is that the NIFTY BANK index comes close.

Theoretically, Hedging works in Theory

The math checks out. Irrespective of whether you hedge against the NIFTY or the NIFTY BANK index, you end up with much lower drawdowns.

For example, if you hedge against the NIFTY BANK, assuming no frictions and slippage, drawdowns never exceeded 20% and returns came in at a respectable 12% annualized.

Reality Sucks

Hedged portfolios have high Sharpe ratios and look attractive in backtests. However, reality is quite different.

βs are not Stable

The chart of rolling betas of the portfolio over different indices highlight the biggest problem with hedging: the hedge ratio needs to be constantly adjusted because the relationships are unstable.

Adjust it too often, then you lose to transaction costs. Adjust it too slowly, then you are no longer perfectly hedged.

βs > 1

Sometimes, betas can exceed 1. This means that your portfolio is net short during those periods. If the original intent of setting up the portfolio + hedges was to just even out the market fluctuations in a long-only portfolio, then being net-short is something that you may not have bargained for.

Margin requirements Vary

The backtest presented above allocates 90% to the cash (long-only) part of the portfolio and 10% towards margin requirements. However, during periods of market stress, brokers are known to hike margins to protect themselves. This might end up putting you in a position where you will need to pare back some of your long-only exposure to raise funds to meet the increased margin requirements. Basically, selling the dip.

Markets have a Positive Drift

Over long time horizons, markets typically have a positive drift. With a hedged portfolio where you are short the market, you are betting that this drift is overshadowed by volatility and portfolio alpha. It may very well be true, but you are betting against the winds.

Who should Hedge?

Leveraged Investors

Hedging doesn’t make sense for long-only cash portfolios. If you are a CNC (Cash N’Carry) investor, then you are better off de-grossing (reducing overall exposure or positions) and focusing on diversification rather than trying to hedge your portfolio.

Investors who employ leverage, however, should hedge. For example, if you were to take levered positions in HDFCBANK and KOTAKBANK through futures, then it makes sense to try and hedge out the market risk. Futures have 5x leverage built in, so it has the potential to boost your CAGR, as long as you can meet the mark-to-market during the 20% drawdowns.

Tactical Positioning

Some investors may prefer to hedge only when they expect market volatility. In our introduction to Tactical Allocation, we touched upon how we can use moving averages to shift between stocks and bonds. Instead of trading in-and-out, investors might prefer to add a hedge instead.

Needless to say, we are not big fans of investors trying to time the market like this.

Conclusion

Hedging makes sense if you are a leveraged investor. Given the costs, complexity and performance drag involved, it doesn’t make much sense for cash investors to hedge.


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