Thinking of Hedging?

While we primarily manage portfolios on a long-only basis at KKRA, we are often asked about our view on hedging market exposure.

The potential benefits of hedging are clear – less volatility, less correlation to market returns, and protection in down markets. But what about the cost of hedging?

We looked at returns of an average hedge fund over the last 10 years vs. S&P 500 Index (as a proxy for a long-only strategy). While there are many different types of hedge funds out there with various strategies, many use derivatives, short selling, and other ways to “hedge” market exposure.

The table below shows that over the last 10 years the returns for an average hedge fund (as measured by Barclay Hedge Fund Index) have significantly lagged those of the broader stock market.

Interestingly, even in 2018, when the market return was negative, an average hedge fund did not provide the downside protection that one would have expected.

So, while hedging can reduce risk and volatility, it can also reduce returns, especially during the periods of strong market runs, like the one we had over the last 10 years. The cost of hedging can be an opportunity cost, but also excessive fees that could come with some hedging strategies. Over time, this cost can be significant. The chart above shows how much of the return you would have given up by applying various hedging strategies on a $1million investment vs. having long-only exposure to the market over the last 10 years.

It is also worth keeping in mind that many hedging strategies can carry “fat tail” risks. This happens when a hedging strategy does not perform as modeled during a period of real market stress or a spike in volatility. This risk can produce rare but significant capital losses. Just this year, we saw hedge fund Melvin Capital lose over 40% of investors’ money on shorting stocks.

Hedging strategies can certainly make sense for those willing to accept potentially lower returns to reduce risk and volatility. It is essential, however, to take the time to understand the strategy and the underlying risks. There are also other ways to reduce portfolio risk, which can include broader portfolio diversification and less aggressive asset class allocation.