In the balance

Fund Strategy - 12 Sep 2011 | By Rodrigo Amaral

High levels of market volatility have highlighted how important it is for investors to assess properly the threats that hang over their portfolios. Many of them have looked for ideas of how to mitigate risks, and at the forefront of this effort are hedging strategies.

Like a motorcyclist taking measures to protect himself against a fall, investors have strived to shield themselves from ugly creatures like inflation, currency roller-coasters and political instability. To achieve this they have benefited from the development of a variety of investment vehicles that aim to take risk out of the equation.

But many of these strategies themselves are costly and risky. If not properly deployed, hedging can achieve the opposite effect of its intended goals. For all the development of financial hedging in recent decades, a risk-free investment policy still looks like a utopia.

Despite this, for many fund managers and other investors hedging has become a fundamental part of their investment strategies. The volume and intensity of risks in the global economy has shot up in recent years, generating uncertainty even about assets once seen as 100% bullet proof, like American treasuries and British gilts.

Extremely low interest rates in developed economies have cast doubt on the ability of investors to deliver performance without taking significant risks in exchange. Politicians in Europe and America have shown impressive levels of ineptitude, while instability in the Middle East has shaken oil markets. Inflation, or even worse, stagflation, looms ominously. Currency fluctuations, always a concern for cross-border investors, appear to have gone out of control. Volatile stockmarkets have added more grey hairs than yields to equity investors. And many have realised that emerging economies, the quintessential risky investments, are likely to be the only sources of growth.

So there is no dearth of arguments for hedging risks. “Hedging is today a consolidated part of the risk management process,” says Sean Glasgow, an investment consultant at Buck Consulting. “It is different than it was eight years ago.”

Of course, selecting certain risk assets and staying away from those that look more challenging is a natural instinct for responsible investors. But hedging often goes a step further by not only distancing investors from things that they do not like, but making a bet against them. In some cases, a portion of a portfolio will be invested in a product that has an inverse correlation to the performance of its main assets. (Cover story continues below)

Sophisticated hedging strategies aim to make sure that even if the market goes against the predictions of, for instance, a fund manager, some money will be made regardless. Even if, in worst-case scenarios, hedging is not enough to deliver returns promised to investors, the idea is that it can help to offset the loss of performance that negative developments entail. Bolder players will make use of such strategies to try to extract large returns out of market volatility, rather than to merely protect the value of a portfolio. That is the realm of hedge funds that advertise the ability to deliver returns no matter what, but whose exposure to risks have been demonstrated by the events of the past three years.

Investment managers who oversee the money of less daring investors, such as retail clients and pension funds, are more likely to use hedging on a defensive basis. They also face more regulatory restrictions than hedge funds on the employment of creative strategies that enable them to take large bets in a portfolio. These will vary according to the family of the funds and the audience they are aimed at. But in a basic way, all funds will do some sort of hedging.

“Fund managers can hedge their risks by underweighting or getting out of the sectors where they believe there is more risk,” says Andrew Clare, a professor of Asset Management at the Cass Business School.

Things become more complicated when the objective is to mitigate the effects of developments that could have an indirect impact on the performance of the fund. Investors have often expressed concerns about geopolitical risks like the popular revolutions in the Middle East, which have helped to fuel volatility. The market’s flight to gold in the past two years can be partly seen as a result of efforts to hedge this kind of risk. This is because precious metals tend to perform better than bonds and equities in times of political uncertainty, according to a note by Schroder Private Banking.

The bank has also noted that, because it works as a reserve for central banks, gold has often been treated by investors as a currency. So it is not unlikely that investors are buying into the precious metal to hedge against currency risk, another concern.

Wild fluctuations of the world’s most important currencies, such as the euro and the dollar, against others such as the Japanese yen and the Swiss franc, have raised plenty of alarms recently. This is a challenge, especially for managers of global bonds or equity funds that have to deliver returns in sterling. As investors move their assets abroad, they become exposed to currencies that are usually prone to volatility in the emerging world. A sharp depreciation of sterling against the currencies of countries where a fund is invested means an automatic boost to returns. However, if the opposite takes place, performance can be severely compromised.

To guarantee they will not be caught in the latter situation, investors can buy forward foreign exchange contracts or currency options that, in practice, revert their exposure to foreign currencies back into sterling. Such arrangements guarantee they will be able to buy sterling back at a rate that will keep returns on track.

Some will use carry trade and other hedging techniques to protect the value of their investments and even make some extra money for the fund. For example, in a recent speech, Stewart Cowley, the head of fixed income at Old Mutual Asset Managers, said the firm’s Strategic Bond fund had employed hedging strategies to act on the view that demand for resources would push up the value of commodity currencies such as the Canadian and Australian dollars.

Another pertinent example is the risk of inflation. Even though developed economies have been barely able to post any kind of economic growth, central bankers have been worried about a spike in prices, mainly driven by global commodity markets. Inflation is not good news for investors, especially those with their sights fixed on the long term. It is a particularly serious concern for pension funds, which need to make sure that assets will be able to meet liabilities when they have to pay out the income they promised to participants. But investors in general ­should be concerned about the extent to which the purchasing power of their assets is eroded by high inflation.

One way of hedging against inflation is to invest in assets that tend to perform well when prices are under upwards pressures. Experts suggest, for instance, to buy commodities or commodities-related derivatives to stave off inflationary effects, as the correlation between inflation and commodity prices tends to be quite high. Equities are often mentioned as inflation hedging alternatives for the long run, although some commentators say there is lack of conclusive evidence to support these claims and stocks in sectors such as financials tend to suffer in inflationary environments.

A more straight-forward solution is to stay in cash or allocate a substantial part of the hedging budget to inflation-linked bonds. These are sold by governments with the promise of paying a fixed coupon linked to an inflation index at the time when the bond is issued. This sounds like a good solution for normal times, where inflation tends to come accompanied by interest rate increases that add some spice to government bonds. But what can investors do when there is a threat of inflation even though sluggish economic growth prevents central banks from raising rates?

To face such a conundrum the market has developed sophisticated products that are often tailor-made according to the hedging needs of a client. “When you speak of hedging, what comes to people’s minds is usually the use of derivatives,” Glasgow says.

A plethora of futures, options, swaps and other over-the-counter products can meet the most varied needs and goals of hedging strategies. In a recent study, for instance, Towers Watson, a consultancy firm, noted that derivatives, like inflation swaps, have the ability to build highly customised hedges, while other assets often used for the same effect, like commodities and equities, offer less complete solutions to the problem.

Derivatives can be used to mitigate risks in many situations, and their use by fund managers and other investors is on the rise. They enable fund managers to deploy sophisticated hedging strategies, but can also be useful for bond investors who can buy interest rate swaps or credit default swaps (CDS) to mitigate the credit risks involved in fixed-income investments. The spreads paid by Greek, Portuguese and Irish CDS contracts in the past couple of years suggest that many investors are making use of such instruments to reduce their exposure to struggling economies. Equity investors may prefer put options that are triggered if a stock price falls below a certain level, which could help to offset the losses suffered by the main holdings of an equity fund in a market slide.

Though they can be useful for a fund manager none of these tools constitutes a solution for all problems that could hamper the performance of an investment portfolio. That is because derivatives, for all their hedging possibilities, create their own set of risks.

First, there is counterparty risk. When investors buy a put option or an inflation swap, they are selling its risk to someone else who thinks the market will move differently. This will usually be investment banks or other such entities that have the firepower and the guts to make risky bets. The success of a hedging strategy based on derivatives hang on the ability of counterparties to meet their commitments if trigger conditions apply. Anyone who still suggests this is not a significant risk need only remember that Lehman Brothers and AIG’s financial unit, which almost doomed the insurer, were active participants in derivative markets.

Derivatives can also prove costly to a point where the hedging exercise becomes a hurdle to performance. As they are products sold according to demand and supply constraints, price is relevant when markets are jittery.

“The cost of hedging when markets are volatile can become high, and managers can conclude that it is not worth the cost,” says Clare. “It’s like buying home insurance in New Orleans after a flood. It will be much more expensive than before the rain.”

A report released by BNY Mellon last year revealed, for instance, that there was a considerable difference between how much fund managers say they will pay for currency hedging strategies and how much higher the costs were.

Glasgow says some derivatives do not work as investors expect during market turmoil. For instance, investors tend to buy options on stocks they say will have a negative correlation to their underlying holdings. But it is often the case that dramatic changes in the market undermines such strategies.

“If the market drops some 15%, for example, stocks tend to be correlated and to drop together,” he says.

Timing is a big factor in hedging, and it is no different when derivatives are used. Glasgow says, when an investor aims to take advantage of small drops in the value of certain assets, it is necessary to be precise in timing it. No-one wants to pay a high price for a put option only to see the trigger conditions take place after it has matured.

To keep hedging tools constantly in place, however, is often uneconomical. In such circumstances investors could find that, even if the hedging works as expected, the costs involved are so high that it would have been better to be invested only in the underlying assets, Glasgow says.

A less expensive choice is to use index-linked products, such as exchange traded funds (ETFs), as a hedging tool. The argument is that such products reflect the performance of whole segments of the market, so they are tools to guarantee short-term protection in times of high volatility.

Short-selling specific sectors via short ETFs is also said to reduce exposure of a portfolio to pitfalls. And, being traded in exchanges, such products offer a level of liquidity that derivatives traded over the counter cannot match. Glasgow says fund managers have taken to some of these ideas, and this is illustrated by the high volumes of index-related trades on the Chicago Board Options Exchange.

“What it probably tells us too is that a lot of that hedging was put on too late,” he says. “It is quite difficult to time hedging.”

So how do fund managers work their hedging strategies in practice? The BlackRock UK Absolute Alpha fund is among the growing range of retail funds in the British market that make significant use of hedging.

According to its co-manager, Nick Osborne, the decision to adopt such strategies depends on the goals of each fund and what it aims to deliver.

The UK Absolute Alpha fund is an equity instrument that looks for opportunities in the British stockmarket. Osborne and his colleagues employ a variety of tools to hedge.

Click to enlarge table

“There will be times when we use index futures, which bring a linear pay-off, and others when we will use options, depending on their cost,” Osborne says. “We used options as a hedging instrument for our fund for the first time back in March. At that time we were quite optimistic about companies’ profitability. Valuations looked pretty low both on an absolute basis and relative to other investments.

“But we were conscious that there were considerable tail risks, like the ongoing sovereign and deficit problems in the developed world and the unrest in the Middle East and Northern Africa, which could have an increasingly material impact on the oil price, and therefore damage global growth. In that case, options protection felt like a sensible hedging tool. We wanted downside protection without inhibiting our ability to profit from the upside.”

He also notes the fund will typically employ 50% of its assets in pairs trades, where similar amounts of capital are allocated to both long and short positions in the same sector.

“We can thus hedge out sector risk and market risk and have a clear focus on the alpha component of the returns,” he says.

“Let’s say we are very positive on a UK retailer who has a very strong balance sheet. We like the fact that it owns all of its properties, and we see a huge opportunity for this company to increase its overseas sourcing, and hence lift profits largely through self-help. But we are nervous about the outlook for the UK consumer. So we could be long on a company where we identify a huge degree of self-help and opportunity, and short on another UK consumer share that doesn’t have the same degree of self-help.”

Osborne also explains that hedging has much to do with making the right choices, as an unbalanced strategy could bring unwanted results.

“Just like every investment, hedging is all about judgment. If you have hedged out all your market risk, and the stockmarkets rise considerably, then the fund will not perform as well as it would have done otherwise.”

In the end, hedging often boils down to a choice between peace of mind and the opportunity to make a quick killing in the market. The performance of Osborne’s fund during the market volatility of 2008 and 2009 demonstrates this trade-off well. In 2008 the stockmarket was down over 30%, and UK Absolute Alpha rose 1.5%. The following year, the stockmarket rallied 30%, but the fund posted an increase of only 8%.

“Taking the cumulative impact of both of those years, you would rather be in the fund than in the stockmarket,” Osborne argues.

What is clear is fund managers have an obligation to communicate their hedging strategies to clients. This entails making the risks clear as well as explaining the possibility of these positions causing a portfolio to lag behind the market during a bull market.

“We tell our clients that there will be times where the market will be strong and we are likely to lag that, but there will be times of weakness where we would expect to perform substantially better,” Osborne says.

Yet, as there seems to be little respite from volatility in markets, experts have warned that the effectiveness of hedging strategies could become deal-breakers for clients when choosing between funds. Glasgow says he has identified a change of perception among investors.

“People are more willing to accept that a long-term horizon and patience are not going to be enough to achieve investment goals while taking risk off the table. Absolute return managers who pursue dynamic asset allocation, moving from one class to the other, have been getting better results than less flexible funds. Diversification is generally the most efficient hedge.”

To receive more relevant articles like this one, why not sign up to our briefings and breaking alerts by clicking here and Follow @fundweb