Listen, if you’re looking to start your week (and your quarter) on an upbeat note, don’t look to Goldman’s John Marshall and Katherine Fogertey for confirmation bias re: any relatively sanguine outlook you might be harboring.
As regular readers know, John and Katherine are always looking out for folks by scouring the market for attractive hedges and other “opportunities”, and on Monday, they want you to know that shit’s gettin’ real out there.
Just read this intro to their latest note found under the subheading “why focus on hedging now?”:
We believe the VIX spike in early February was a significant event for investors, made even more significant last week as we revisited the YTD lows in the S&P 500. S&P 500 realized volatility was 6.8 in 2017 and has nearly tripled to 20.3 thus far in 2018. We expect the increase in realized volatility to have direct effects on the calculation of risk in a variety of equity portfolios (when volatility rises, position sizes need to decrease to maintain the same dollar-volatility risk). The spike in VIX and realized volatility was large enough for investors outside the equity market to take notice and could lead to a reduction in risk-taking appetite on the margin in the coming months. It was yet another symptom of the market fragility created by lower liquidity. We believe that a shift towards risk reduction and expectation of higher volatility is likely to change the trading dynamics in 2018 and increase the value of time spent on hedging. More recently, open interest data reveals that a large number of S&P 500 hedges have expired over the past three weeks, leaving the average investor less hedged.
Well at least it’s good to know that the “value of time spent on hedging” will increase, because the “value” of that time over the pasts couple of years has been negligible at best and negative at worst to the extent you were willing to go out on a limb and forego the opportunity to harvest carry while your peers basked in the glory of the short vol. trade in all its various manifestations.
As an aside: the reference to “market fragility created by lower liquidity” in the excerpted passage above is to a recent piece we profiled in “Goldman Delivers Ominous Message: ‘Markets Themselves’ May Pose The Greatest Risk”.
Next, John and Katherine take you through the “hedging process” an exercise which, frankly, includes a lot of tautological reasoning like “hedge what you own” and “hedge when the risk is greatest.” I mean what would be the opposite of that? Hedge what you don’t own and hedge when there’s no risk?
But hey, who are we to say what’s useful and what’s not, so here’s the instruction manual for hedging:
- Hedge what you fear: Hedging specific factors that could be subject to high volatility or drawdown risk can be an effective method for protecting a portfolio. With this method, investors have the potential to add alpha during the hedging process by choosing to protect against moves in select factors while remaining exposed to others. The emphasis of this method is assessing the efficiency of the hedge relative to the factor sensitivity rather than portfolio sensitivity. In some cases, a portfolio may already be positioned for a factor move (like higher rates), and the hedge may be positioned in the same direction (puts on treasuries) to capture not only the linear move but also the asymmetric returns associated with buying options that under-price that risk.
- Hedge what you own: Hedging with instruments that have high correlation (low tracking error) to a portfolio provides the most reliable hedge in a wide range of adverse scenarios. This is typically the best approach when you have a view on the timing of a sell-off, but lack a strong view on which factor is likely to drive an increase in volatility. A hedged portfolio allows one to capture the upside part of the return distribution while limiting downside. This approach requires careful analysis of the major drivers of the specific portfolio’s returns and constructing a hedge that is most efficient based on current options prices. The downside to this hedging strategy is that it also hedges your alpha. Typically investors buy specific stocks and factors they expect to have asymmetric upside; by hedging these same factors, they erode the outperformance benefits if they are correct.
- Hedge when the risk is greatest: Timing the implementation of hedges is one of the most challenging aspects of the process. Timing can be improved by tracking risk metrics that relate to the probability of increased volatility or drawdowns. Likewise, careful attention to the calendar of events and recent volatility on those events can add value. Many investors choose to forgo the alpha from timing hedges and develop low cost hedges to allow for constant protection through time.
- Hedging large drawdowns vs small drawdowns: Hedging against extreme events often requires a different process than hedging against more moderate volatility. Large drawdowns necessarily have a lower probability of occurring than small drawdowns and are often driven by non-linear processes that require different modeling techniques. Careful assessment of the probabilities priced into options strikes of different strikes, terms and across assets can provide increased flexibility for efficiently hedging tail risk.
Again, all of that is self-evident and there is no case in which it would make sense to say the opposite of anything noted in those bullet points. But I suppose if you’re the type of person who doesn’t understand what hedges is and what they does (bad grammar there is intentional, so don’t forget to laugh), the above is helpful.
What’s more useful than that list of tautologies is the following fun diagram rendered in pleasing hues of blue which gives you some stock and index-level ideas for hedging various bogeymen:
Finally, for the serious among you (i.e. for those of you who aren’t just reading this for entertainment), here is a table with some actual numbers and other tradable information: