Video: Hedge market risks: Review your goals
Get asset allocation right, including quality bonds and alternatives
A diversified asset allocation is one of the best ways to manage market risks, in our view. Government bond yields in USD, EUR, and GBP have risen significantly to account for higher oil prices. But they may not climb higher even if oil prices remain elevated, as investors will likely begin to price in adverse growth effects and the potential for lower rates. We therefore like locking in elevated yields up to 10 years out on the curve. And we believe quality bonds will retain their role as portfolio diversifiers, especially if recession fears begin to rise. We favor short- to medium-maturity bonds in general. For investors still concerned about the longer-term inflationary outlook and seeking a less correlated asset, an allocation to US inflation-linked bonds (TIPS) may be preferred to nominal bonds for those investors. An allocation to hedge funds may also help mitigate drawdowns and smooth returns, particularly as cross-asset volatility increases.
Substitute direct equity exposure for capital preservation strategies
Trading geopolitics has historically been a recipe for disappointment. Rather than taking bold directional views, we recommend that investors concerned about downside risks consider capital preservation strategies that offer participation in market upside while potentially limiting some downside risk. In particular, investors should consider using these in areas that have held up well, but which are cyclical, expensive, or susceptible to a prolonged energy shock.
Capital preservation notes can be customized for tenor, loss avoidance, and participation, allowing investors to tailor the degree of capital preservation and participation in market gains. Variants such as “bearish notes” and “twin-win” strategies can offer flexibility for different market views. The predefined loss limits can help investors stay invested during downturns, reducing the temptation to sell and lock in losses.
The sharp move higher in many governments’ shorter-dated bonds could make zero-coupon bonds cheaper, increasing the capital available for options and thus participation in market gains. However, investors must also monitor implied volatility, as higher option prices can reduce participation rates.
Consider currency hedges
The near-term outlook for the US dollar is likely one of strength amid higher energy prices, but its structural headwinds remain, including the US twin deficits and heavy global allocations to USD assets. Aligning portfolio currencies with liabilities and spending plans may help investors reduce the risk of potentially large currency swings undermining financial goals. According to the latest Global Investment Returns Yearbook, currency risk on average added around 6 percentage points to total portfolio risk. To manage this, investors may want to consider balanced portfolios hedged into their desired currencies, shifting investment grade fixed income holdings into underallocated currencies, currency hedging overseas equity exposures, or using derivatives such as currency forwards, options, and structured solutions. These instruments, however, introduce additional risks, such as leverage and margin calls.
