Hedging a portfolio to reduce or prevent losses during market sell-offs sounds like a no-brainer. But in practice, investors must consider several factors before they can start hedging.
For example, investors tend to overpay for their protection, resulting in a performance drag.
Most investors turn to the US's S&P 500 to buy protection due to its liquidity and high correlation to global equities. This demand for protection on the S&P 500 makes out-of-the-money put options disproportionately expensive if you compare them to other equity markets.
Also, the question of when to buy protection is difficult. Investors often hedge at the worst possible time by buying protection after a stock market sell-off, when hedging costs have already risen.
We suggest adopting an always-on hedge and applying a rigorous methodology to avoid expensive insurance. Our Systematic Hedging philosophy encompasses the following steps: First, we analyzed 18 major equity indices that have liquid option markets. From there, we identify correlated drawdowns during the indices that exhibit volatile and correlated drawdowns during global market sell-offs. We then recommend buying protection on the selected indices when prices levels are, in our view, “cheap.”
For more information on our favorite indices, please refer to our publication "Volatility: CIO Systematic hedging – March" published 13 March 2017.
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