Some hedges can prove to be costly insurance after the risk event has passed. (UBS)

The VIX Index, a measure of expected US equity volatility, is nine points above its 2023 lows, although it remains below its 2022 average of 25.5. But, we think it’s still possible to identify portfolio hedges that can protect wealth against three of the market risks most concerning investors:

Hedging an escalation in the Israel-Hamas war. In our base case, we expect the war to stay confined to Hamas and Israel in the geographical areas under their respective control. Impacts on global financial markets should eventually subside. We would expect greater asset price swings in the event of a regional escalation that draws in other nations, such as Iran.

Widening conflict in the Middle East would most affect global markets through sharply higher oil prices. There is a risk that Brent crude climbs to the level of USD 120/bbl mark (or above) last experienced at the onset of the Russia-Ukraine war, given fears of disruption (for example through a blockade of the Strait of Hormuz) or a cessation of Iran’s 1.5 million barrels a day of oil exports. Long futures positions on Brent crude oil or options structures that gain when oil prices climb are the best means of hedging such a scenario, in our view.

After oil, we think the next most preferable hedge would be gold, which is considered a safe haven against geopolitical instability, and which has already risen by around 8% since the Israel-Hamas war began.

Safe-haven currencies such as the US dollar, Swiss franc, and Japanese yen may rally in such a scenario, though they may be less effective hedges if central bank actions to promote financial stability lead to direct or indirect currency weakening. Similarly, US Treasuries are a less appealing hedge, as the recent climb in government bond yields suggests growth and technical factors remain more important performance drivers than the “flight to quality.”

Hedging further increases in high-quality bond yields. In our base case, we expect 10-year US Treasury yields to decline to 3.5% by end-June next year from near 5% today, in response to slowing US economic growth and further moderation in inflation in early 2024. Even in our most optimistic scenario of above-trend US growth and higher-for-longer interest rates, we see limited scope for longer-dated US yields to overshoot 5%.

In Treasuries, the current volatility leads us to prefer five-year duration relative to ten-year duration to earn yield and to mitigate the risk that ten-year yields continue to rise. This is our preferred hedge for investors concerned that uncertainty over large US fiscal deficits and increased supply of Treasuries to the market could put further upward pressure on the “term premium” (the compensation needed to entice investors to hold long-dated over short-dated US Treasuries). Longer-duration yields are more sensitive to changes in technical and supply issues than those of shorter duration.

Other hedging ideas include credit default swaps, a financial investment that aims to insure an investor against the default of a borrower. This is a less accessible and appealing hedge, however, based on factors such as market liquidity, minimum size of implementation, and market mispricing arising from arbitrage trades.

Hedging against sharp equity declines. Our best ideas for shielding wealth from stock market falls depend on the main driver of losses. For investors able to use options, switching equity exposure into capital preservation strategies would likely be the best hedge in downside scenarios resulting from a short-lived “shock” that leads to a spike in equity volatility. These strategies combine a zero-coupon bond with long positions in call options. This helps investors to remain in the markets, since principal is preserved if the strategy is held to maturity. Liquidity risks apply if investors need to sell before maturity. Changes in interest rates, implied volatility, and dividend levels are factors to watch for their pricing impacts.

Alternatively, investors can consider hedging by switching into more defensive equity sectors. Here, we see value in increasing exposure to sectors like global consumer staples, whose performance is less tied to the global economic cycle, and reducing exposure to the more cyclical materials sector. This aligns with our global equity sector preferences.

Not all investors are able or willing to hedge. Geopolitical and political events are unpredictable. Some hedges can prove to be costly insurance after the risk event has passed. And adjusting hedges can be complex in fast-moving markets.

So, another approach is to maintain a diversified portfolio that invests across asset classes, regions, and geographies. In our base case, we expect cash, bonds, stocks, and alternatives all to deliver good returns over the next 6–12 months and over the longer term. We believe that investors who review their portfolios and ensure an effective balance across asset classes will be well positioned to manage potential risks and earn durable long-term returns.

For more specific hedging ideas including through options markets please see “Global risk radar: Hedging ideas for UBS House View scenarios” 18 October 2023).

Investors in options need to be aware of the risks. An option buyer faces the risk of losing the entire amount of the premium paid. An option writer faces a higher level of risk, as the potential loss can be significant if the option expires in-the-money. Investors must understand the risks associated with capital-preservation approaches. These include a default of the issuer or the product's guarantor, limited secondary market liquidity, and the potential for capital-preservation features only being provided at maturity.

Main contributors - Solita Marcelli, Mark Haefele, Dirk Effenberger, Frederick Mellors, Moritz Vontobel, Matthew Carter

Original report - How to hedge threats to your portfolio, 20 October 2023.