While considering ways to adapt to the shifting market environment, investors can look to the risks and rewards of a hedged equity exchange traded fund strategy.

In the recent webcast, Know What You Own: Understanding the Risks and Rewards of Hedged Equity, Swan Global’s client portfolio manager Marc Odo and COO and portfolio manager Rob Swan warned that interest rates are more likely to go up than down, which means that the easy returns from the three-decade long bull run in fixed income assets will come to an end. To put this lower return outlook in perspective, from 1945 to 1981, when interest rates gradually rose up above 14%, a traditional 60/40 portfolio showed an average real annual return of 3.08%. From 1982 to 2020, when interest rates gradually fell to their near-zero levels today, a 60/40 portfolio returned an average of 7.48%.

Swan Global also argued that investors should always maintain a hedge to mitigate risks. Investors need some kind of hedge that addresses left tail risks like a market crisis, COVID-19, large loss, and a long recovery process, while simultaneously tackling right tail risks like under-allocation to equities and missing out on potential returns.

As a way to maintain equity market exposure with some downside protection, investors can turn to the Swan Hedged Equity U.S. Large-Cap ETF (HEGD).

The Swan Hedged Equity U.S. Large-Cap ETF 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 as a means to generate additional return to offset the cost of the hedge.

HEGD uses Long-term Equity Anticipation, or LEAP, option 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 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 value of put options.

The monetization of hedge 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 manages 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 as a means of mitigating downside risk or volatility.

Swan Global argued that while option-based strategies tend to get a bad reputation due to excessive leverage, lack of liquidity, or poor risk controls, a well-managed investment strategy can determine how options are used to optimize positions.

Financial advisors who are interested in learning more about hedged equity strategies can watch the webcast here on demand.