Investors should consider the benefits and risks of hedged equity exchange traded fund strategies and the best practices when utilizing these alternative strategies to address market risks.
In the recent webcast, How Hedged Equity Strategies Help Prepare for Bull and Bear Markets, Rob Swan, COO and portfolio manager at Swan Global Investments, noted that the last 35-plus years have been a huge bull market in bonds as interest rates fell to all-time lows, but we must consider the state of fixed income today and what they will look like ahead.
Swan warned that interest rates in the U.S. are beginning to rise, so the bull market in bonds may be running on fumes, which means the performance of the traditional 60/40 stock and bond portfolio going forward will look very different if investors want to maintain the same level of returns from yesteryear.
In anticipation of the headwinds ahead, Swan argued that investors need to find the right balance between market exposure and managing further risks. Investors need some kind of hedge that addresses left tail risks like a market crisis, significant loss, and a long recovery process while simultaneously tackling right tail risks like under-allocation to equities and missing out on potential returns ahead.
As a way to maintain equity market exposure with some downside protection, investors could turn to something like the Swan Hedged Equity U.S. Large-Cap ETF (HEGD).
HEGD can be seen as a “potential solution for the ‘dual dilemma’ of low bond yields and expensive stocks,” Swan said.
Marc Odo, client portfolio manager at Swan Global Investments, noted that the hedging strategy aims to invest with downside protection as the goal.
HEGD is always passively invested in S&P 500 Index ETFs, and it hedges against this equity-side risk through actively managed long-term put options purchased at or near the money to mitigate risks of bear markets. Finally, HEGD has actively managed option trades utilizing a disciplined, time-tested approach to generate an additional return to offset the hedge cost.
“Sadly, some investors regard all options strategies as ticking time bombs,” Odo said. “Options are simply a tool, neither good or bad. How options are used is what matters, not if options are used.”
Specifically, Odo highlighted typical so-called blow-up events that can be attributed to leverage, liquidity, and risk controls. These factors are responsible for many financial crises, not just those in the options space.
HEGD uses long-term equity anticipation or LEAP options contracts that expire at least one year from the date of purchase. The long-term hedge is used because it may last longer than bear markets, may not be under duress to re-hedge during a crisis, and may provide the opportunity to acquire more shares of underlying equity ETFs during major market sell-offs. The hedge is also rolled annually so that the portfolio is always hedged and mitigates exposure to declines in the value of put options.
The monetization of hedges in large market moves provides cash for buying at market lows and protection of gains in rallies. Additionally, active management is designed to take advantage of market opportunities since the managers are not constrained by calendar or hedge contract expiration. In comparison, a passive put spread collar could experience capped upside, full downside market exposure, hedges that expire in unfavorable times, hedges that expire worthless if the market is above the strike price, and no room for active management to optimize real-time moves.
HEGD can also serve different objectives for different investor types. For example, it may help increase return potential while maintaining a similar risk target for traditional allocation. The strategy can help shift cash off the sidelines and remain invested to increase market exposure. Finally, the ETF can help re-allocate to equity positions to mitigate downside risk or volatility while maintaining a level of equity upside exposure.
Financial advisors who are interested in learning more about the hedged equity strategy can watch the webcast here on demand.