Hedging market risk in a diversified investment portfolio

Stephen A. Rossi, BridgeTower Media Newswires

When we speak of hedging market risk in an otherwise diversified investment portfolio, what we’re really talking about is buying something whose value goes up, when the general market (i.e. stocks) goes down. There are several ways to accomplish this, but always at a cost, and always with the assumption of a new set of risks to accompany the associated reward.

The easiest, safest, and arguably most effective way to hedge market risk is to purchase U.S. Treasury bonds. Treasury bonds are readily available, they’re easy to buy and sell, and they come with the explicit guarantee of the U.S. Government. As an asset class, their returns are also negatively correlated with stocks, which means their prices tend to go up when stock prices go down. Using this strategy to hedge market risk amounts to nothing more than buying Treasury bonds, in an effort to more conservatively alter the allocation of your portfolio, and reduce its risk profile in the process. Clearly, less risk means less reward, but the risk of loss on a Treasury bond is near zero, as you can never lose more than your initial investment — assuming you hold the bonds to maturity, and the U.S. Government doesn’t default.

Another common and fairly safe way to hedge market risk is to purchase a put option on a specific security, or on an investment that mimics a general market index like the S&P 500. Buying a put option provides an investor with the right, but not the obligation, to sell a specified number of shares of the security, at a certain price, on or before a certain date. Hypothetically, if the S&P 500 Index was trading at 3,098 and an investor wanted to protect their portfolio (i.e. hedge) against the possibility of the index falling below 3,000, the individual would buy a put option on a substantially similar security with a “strike price” of 3,000. If the index doesn’t fall below 3,000 before the option expires, the investor loses only the initial cost of the option (i.e. no hedge was necessary). If the index does fall below 3,000 before some specified expiration date, the individual could exercise his/her option to sell shares of the security at 3,000, to avoid the principal loss that otherwise would have resulted in their portfolio. Here the hedge is effective, since the gain on the exercised option offsets the loss on the investor’s portfolio assets.

In buying a put option, you pay for downside protection, and you can never lose more than what you paid for the option. However, the options are only good for a specific period of time (i.e., they expire), so they may need to be purchased somewhat frequently to maintain a “hedged” position. Buying put options is inexpensive, and it can be a relatively tax-efficient strategy, since you don’t have to sell stock and realize potential capital gains in order to take advantage of it.

Buying inverse Exchange Traded Funds (ETFs) is a third way to hedge market risk. Here, the investor can buy/sell a fund that trades just like a stock, but whose price action is designed to be the opposite of some specified market index — sometimes even two or three times opposite. For example, buying the ProShares Short S&P 500 ETF is designed to generate a return (before management fees and trading costs) that is the exact opposite of the return of the S&P 500 index on any particular day. On that day, if the S&P 500 Index goes up 1%, the value of the ProShares Short S&P 500 ETF would be expected to go down 1%. Inverse ETFs accomplish this by selling securities short, and by selling forward and futures contracts — more on that later. Suffice it to say, however, that these instruments are best left to sophisticated investors who understand exactly what they’re buying. True, they’re easy to buy and sell, and you can never lose more than your initial investment, but the added cost of management/trading, and the effects of compounding returns when the market is trending in one direction or another, can dramatically impact your investment results. These effects can often disappoint investors who don’t truly understand what’s going on under the hood.

Some of the most sophisticated and risky market-hedging strategies involve selling securities short and/or selling forward and futures contracts. Unlike the strategies discussed above, these strategies have potentially unlimited downside risk and require the use of a “margin account.” A margin account allows an investor to lend their securities to others for some marginal benefit, or to borrow securities from a third party at some marginal cost.

Selling securities short to hedge market risk involves borrowing a security you don’t already own and selling it, expecting its price to go down so you can buy it back cheaper at a later date and realize a gain. You effectively borrow the securities from another investor and pay interest for the right to do so in a margin account. The problem with this strategy is that, if the shares go up instead of down, you might receive a “margin call,” where you’re forced to either deposit additional capital into the account or otherwise buy the securities back at a much higher price, in order to return them to the original owner.

Hedging market risk by selling forward contracts against something like an interest rate index (i.e., betting that rates will go down), or selling futures contracts against the price of a commodity (i.e., betting that the price of the commodity will fall), work much the same way as selling short, and also require a margin account. In these cases, if the value of the security, interest rate index or commodity falls after one of these strategies is deployed, the hedge worked and the gain from the strategy offsets some or all of the loss on the investor’s portfolio assets. However, if the asset’s price or interest rate index subsequently rises, the individual can be left with a potentially unlimited risk of loss.

This is not an exhaustive list of hedging strategies and you should work with a trained financial advisor to understand which, if any, of these strategies is right for you. Some investors are firm believers in a “keep it simple” approach, while others are attracted to a much more complicated risk abatement program. Whatever the case may be, it’s important to fully understand the costs and benefits of the strategy chosen, so the hedge you deploy doesn’t result in an unexpected haircut.


Stephen A. Rossi is senior vice president and senior equity strategist at Canandaigua National Bank & Trust Co.