Warning flags went off around the market when data came out that U.S. inflation has risen above 4% the week of May 10th 2021.

Has the first four months of 2021 started a transitionary period for markets?  While the overall theme has pivoted from economic uncertainties due to COVID-19 related quarantines to concerns that the economy may overheat. Drivers of this pivot seem to be a faster-than-expected economic recovery coupled with record fiscal and monetary stimulus supplied by the Federal Reserve and the Federal Government.

But there is more than just a solid history of the markets freaking out when inflation passes 4%. The 4% logic isn’t written in stone, but it has excellent historical support. Since the S&P 500 was created in 1957, U.S. inflation has risen above 4% nine times, and in eight of those instances, stocks were lower three months later.

So, should the Federal Reserve take their foot off the breaks and raise the Federal Funds rate to slow down their current monetary stimulus programs and mitigate a potential spike in inflation? Maybe. Yet, Fed Chair Jerome Powell remains relatively dovish. What if the Fed policy remains too accommodative, and the U.S. economy does see significant and sustained inflation?

There have been several instances where varying levels of inflation were realized when the Federal Reserve was too dovish relative to the sentiment of the market, which is where we seem to find ourselves currently.

Recent history suggests that some of the technological efficiencies that have been achieved through innovation over the past 10-15 years have reduced some of the impacts that demand has historically had on inflation.

Three scenarios for a stock crash, two decades apart:

The 1960’s – If you believe there is the problem of stocks being extremely expensive, then when bond yields finally start to rise, like in the 1960s, investor ssuffered: The S&P lost more than a third of its value over the next 18 months.

The 1980′ – In 1987, the extreme run-up in stocks ended in a crash shortly after inflation passed 4%.

The 2000s’ – In 2007, the bubble was in commodities, housing, and debt rather than stocks, but the start of the decline in the S&P coincided almost precisely with inflation passing 4%, before turning into a financial crisis.

However, it is crucial to consider that the record amount of stimulus provided by the Federal Government coupled with a record amount of monetary stimulus provided from the Federal Reserve may change the calculus in terms of the level of inflation we can expect and its durability.

We believe that US equities are richly priced by almost all measures. Plus, the U.S. market is dominated by big technology companies and other growth stocks that are very sensitive to bond yields and so likely to fall further if yields rise quickly.

So, in today’s environment, many investors are looking for other ways to mitigate risk while seeking necessary long-term portfolio growth, regardless of the Fed and the impact of inflation. Fortunately, as we discussed last quarter, there is a new class of Hedged Equity ETFs blazing a trail in which hedging is used for “Good” to provide a buffered downside. By utilizing a hedging strategy to mitigate the impact of a significant market drawdown, investors may be better positioned for an eventual market recovery.

Within that catch-all category, there are essentially three groups of strategies that seek to use options to primarily serve different objectives: to hedge, to generate income, or to provide alpha in some manner. In the hedging group, one can see essentially three types: Hedged Equity Strategies, Buffered Strategies, Tail Risk Strategies.

Again we choose the namesake ETF – HEGD to show how this active manager uses passive ETFs to buy-and-hold a long equity position and then uses two forms of options to: 1) create a long-term hedge and 2) try to offset the hedge cost.

HEDG Profile

The Swan Hedged Equity U.S. Large-Cap ETF invests about 90% of its assets in an S&P 500-style (cap-weighted) U.S. large-cap ETF for the bulk of its equity exposure. It then invests in long-term put options, generally 1-2 years in duration, for hedging purposes. The last component is primarily a combination of calls and call spreads, seeking an additional return to help offset the hedge cost, like a “hedge on the hedge.” HEGD combines a passively held equity ETF, with an actively managed long-term hedge and options strategies. HEGD intends to maintain its ETF portfolio indefinitely while the options are bought and sold based on market conditions. Rebalancing the equity and hedge position occurs annually, seeking to keep a roughly 90% equity allocation. The Fund’s Investment Philosophy is: Always Invested, Always Hedged (Protected)

The Hedged Equity ETF is unique in its use and active management of this long-term put hedge. Frist, most hedged strategies use shorter-term hedging intervals, like 90-days, and passively hold those positions until expiration. HEGD is distinct in its use of longer put options, longer than the typical bear market even, in an effort to avoid being under pressure to seek protection when the markets are in free fall. Second, the manager’s active hedge approach also sets it apart. After big moves, the Fund seeks to reset the hedge,  raising the hedge level underneath big market up moves and using large market drawdowns to monetize its long-term hedge position in order to buy additional equity shares at lower market prices while resetting the hedge.

For example, let’s say in a sell-off of 30%, the Fund can sell what would be a valuable 2-year Put-Option for a premium and then reset the hedge near new market levels. The remaining proceeds are used to buy more Large-Cap ETF shares, which may better position the investors to springboard into an eventual market recovery. This strategy aims to have the potential for more consistent risk-adjusted returns through market cycles.

WHY REMAIN HEGDED

Going forward, if bond yields remain low the return outlook is meager for bonds, but if inflation and rates rise then bonds may present real risk to principal. This is a longer-term problem investors must wrestle with as they seek to optimize portfolios for the future.

So if you believe that 4% inflation is a key indicator or a future market downturn, why not put 30% of your portfolio from, say, your bond allocation, which is likely underperforming, to a hedged equity position. That change could serve you well if history repeats itself.

Those that fail to learn from history are doomed to repeat it. Consider taking a deep dive to learn about the advantages of the Hedged Equity ETFs that are hedging for “Good” to protect your portfolio from a potential downturn, now that inflation is over four percent.