While the multi-year bull market may feel like it has created some distance from the market turmoil, investors won’t soon forget the global financial crisis of 2008-2009 and the eurozone debt crisis events of 2010-2011. These experiences made investors painfully aware of the impact large market drops can have on a portfolio and the importance of preparing for such drops with investments that may serve as market hedges. Recovering from large losses can take years if not decades to achieve, which may put long-term financial goals at risk.

Recent market volatility is a reminder that investors should be as focused on capital preservation as they are on capital appreciation. This means having discussions with a financial advisor about investments that offer the potential to shield your portfolio from – i.e., hedge against – some of the effects of market downturns.

In this blog series, I will look at the track record of commonly used market hedges, discuss the historical benefits of using volatility as a hedge, and talk about issues investors need to know about accessing volatility-related products.

Traditional hedges have delivered mixed results

We know future market downturns will occur, but we don’t know when or how severe they may be. History shows us commonly used market hedges like US Treasuries and gold have not always provided a consistent hedge against equity market downturns. In fact, in the worst-performing equity environments of the last two decades, bonds and gold have not always performed well. Furthermore, these hedges can be impaired by external factors such as central bank bond purchases and low real interest rates.

On paper, the case for volatility as a market hedge is compelling. Historically, volatility (the annualized standard deviation of index returns) has been the most widely accepted gauge of market fear and, as seen by its highly negative correlation in Figure 1, has consistently moved in the opposite direction of equity markets. (Correlation measures how closely two asset classes have moved together over time. Perfect correlation of 1.00 means that the asset classes moved up and down identically. Perfect negative correlation of -1.00 means that they always moved in opposite directions.) In addition to providing a consistent negative correlation to the S&P 500® Index, volatility also has generated significant positive returns in the worst-performing equity environments of 1990 to 2014, and has done so with great consistency during that time period, as seen in Figure 2.

We believe these characteristics make volatility an attractive option for investors seeking to potentially hedge against falls in the stock market, and interest in volatility-related products has soared.

Figure 1