Key Takeaways
Periods of uncertainty often make investors want to reduce risk in their portfolios. A hedging strategy may help investors manage risk while they remain invested for long-term growth.
- Successful investing often requires balancing long-term growth objectives with the realities of short-term market volatility.
- While diversification and disciplined portfolio construction remain foundational investment principles, periods of heightened uncertainty can prompt investors to consider additional strategies to help protect their portfolios.
- Hedging is a risk management approach designed to help reduce the impact of adverse market movements while allowing investors to maintain their long-term investment positions.
How portfolio construction helps manage risk
The first and most basic strategy for managing investment risk is to build a high quality, well-diversified portfolio that can perform well across a variety of environments. Doing so typically involves:
- Selecting high-quality companies or indexes to invest in
- Investing in well-understood businesses or sectors
- Using asset allocation to diversify a portfolio
These are all time-tested techniques that will see most investors through a range of market cycles. But sometimes investors may feel that this isn’t enough. They might be worried about near-term market corrections—even while they are confident about the long-term prospects of their holdings—and want to take additional steps to protect their portfolio.
Selling securities may reduce risk but can have undesirable tradeoffs
One strategy that even well-diversified investors might consider when worried about near-term risk is selling securities—in particular, selling equities or other securities that they see as particularly susceptible to a market downturn. Selling securities can indeed reduce risk, but often involves significant costs or difficulties, including:
- Realizing taxable gains—Selling may trigger substantial taxable gains depending on how long the securities were held and an investor's tax bracket;
- Disrupting a carefully constructed portfolio—You may be a buy-and-hold investor with high conviction, long-term holdings you don’t want to sell despite some near-term concerns about the market; or
- Restricted stock—You might hold stock that is restricted from being sold, perhaps as part of an employment agreement.
How hedging works as a tool for managing investment risk
Portfolio hedging is a risk management strategy in which investors seek to mitigate losses on assets in their portfolio by taking offsetting positions in related assets. Hedging may be deployed alongside a diversified portfolio and can help avoid many of the trade-offs of selling securities.
- When markets fall, a hedge is designed to rise in value, and therefore protect your portfolio against losses you would have otherwise experienced.
- Investors may choose to hedge a single investment, multiple positions, a sector or segment of the market, or in many cases, the entire market.
For example, an investor may hold a broadly diversified portfolio of stocks that is generally similar to the S&P 500, yet worry about the potential for a significant near-term decline in the S&P 500. By implementing a hedge, or an investment that gains in value when the S&P 500 falls, this investor can cushion some of the impact of such a market move on their portfolio, since part of the losses in their stock portfolio can be offset by gains in their hedge.
Let’s take a look at a real-life example of how hedging works in practice, and what the impact could be on your portfolio in various market environments.
Performance above represents, for the S&P 500 portfolio, $100 allocated to the S&P 500 Index, and for the S&P 500 with 50% Hedge portfolio, $100 allocated to the S&P 500 Index and $50 allocated to the inverse daily return of the S&P 500 Index. The hedged portfolio is rebalanced to a target of 50% of the S&P 500 exposure whenever this level of exposure exceeds 60% or falls below 40%. S&P 500 Index returns are for illustrative purposes only and do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. The chart above is not representative of actual performance and is meant to illustrate how a hedged portfolio might perform over a market cycle against a commonly used benchmark (S&P 500 Index). The outcome shown is hypothetical in nature and actual performance will vary. Source: Bloomberg
The 2022-2023 period illustrates how hedging can be quite valuable during down markets, but can also result in capturing less upside when markets are rising.
This demonstrates the importance of having a clear view of your objectives, monitoring your investments against market conditions, and making adjustments when needed.
What are the potential benefits of hedging?
Hedging may provide many advantages that other strategies—such as selling securities—don't offer, including:
Avoiding near-term taxable gains
By using a hedge, you may not have to realize taxable gains that you might incur if you had chosen instead to sell securities.
Avoiding adjustments to a carefully constructed portfolio
By using a market-based hedge, you can potentially avoid selling high-conviction securities you may hold as part of a long-term portfolio or asset allocation strategy.
Reducing risk on illiquid positions
If you hold securities that may be difficult to sell, hedging can offer a convenient way to limit the risk of those securities in the near term.
Hedging can be a valuable complement to a well-constructed portfolio, helping investors manage downside risk while remaining focused on their long-term investment objectives.