This blog examines a few simple and widely used approaches to systematic hedging such as short and long dated out-of-the-money (OTM) puts and put spreads as well as VIX futures. We find no single strategy is demonstrably superior at all times, but that the effectiveness of a strategy is a function of the market environment it is deployed in. For more detail, please see the full report "Exploring Systematic Hedging Strategies for Equity Portfolios" published on July 2nd 2019.
Employing systematic hedging on equity portfolios has generally been viewed as a drag on portfolio performance. That is true in the same sense that most kinds of insurance are a drag on performance – until they are not. Systematic hedging of equity risk should generally not be viewed as an alternative to holding a well-diversified portfolio.
Generally short dated puts suffer from more rapid time decay than long dated puts and benefit less from spikes in implied volatility. On the other hand, they are more responsive to market moves and less likely to suffer from "strike sensitivity" or drift away from the strike level in a rising market, thereby providing less protection if equities fall. Put spreads offer protection on a greater proportion of an equity portfolio for a given dollar outlay, but only down to the lower strike of the put spread. VIX futures are usually extremely responsive in market selloffs, but their price declines quickly as the speed of the market decline slows. In addition VIX often, but not always, suffers from costly roll-down because the VIX curve is usually positively sloped. On the other hand, VIX is less exposed to "strike sensitivity" than conventional puts.
In this blog, we review some common approaches to systematic hedging of equity portfolios and point out the pros and cons of each. As is the case when considering any investment strategy, one needs to be forward looking. Data mining exercises do not yield reliable guides to action. Nevertheless, mainly for illustrative purposes, we show simulated historical performance of such hedging strategies for the S&P over the period 2005 - today.
The chart below shows the resulting net underperformance or cost of four different hedge strategies, while the table compares the portfolio measures of an outright position in the S&P 500 versus that for these different hedge strategies. The full research report provides more in depth analysis of these strategies and performance since end-2011, along with a comparison to a 50/50 equity/long-duration bond portfolio.
Hedge Gains/Costs - Assume an investment of $100 million in S&P Index on January 4th 2005
Bloomberg, data are up to Feb. 28th 2019
Portfolio measures for the S&P 500 versus different hedge strategies (since January 4th 2005)
Bloomberg, data are up to Feb. 28th 2019
In summary, there is no right or wrong hedge as it depends upon the market environment, as different strategies outperform in different years. Net, we recommend that investors have a well-diversified portfolio. The choice to hedge should be based on investors' risk tolerances, and their expectations of what the future will bring. While being hedged 100% of the time has not proved economical in the bull market over the past decade, the risk of not being in the market versus a partially hedged position can also weigh on returns.
Disclaimer
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Author:
Vinay Pande, Head of Trading Strategies, UBS Financial Services Inc. (UBS FS); Jerry Lucas, Strategist, UBS Financial Services Inc. (UBS FS); Yang Tang, Strategist, UBS Financial Services Inc. (UBS FS); Tze Shao, Analyst, UBS Switzerland AG; Miguel Costa, Strategist, UBS AG; Jason Draho, Head Asset Allocation Americas, UBS Financial Services Inc. (UBS FS)
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Appendix
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