Taming animal spirits: Tail-risk hedging

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below. 

Please note: All data referenced in this article are sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key points

• Despite equity markets’ strong performance in 2024, concerns about a potential global economic slowdown remain – and the possibility of a market sell-off cannot be ignored
• Short-term hedging strategies can offer a way for investors to keep their portfolios diversified over the long term, and manage potential risks regardless of whether the economy performs better or worse than anticipated 
• Our research suggests that investing in cash positions or defensive US equity long-short strategies have historically offered robust portfolio protection during significant downturns (when the S&P 500 sells-off by at least 10%) 
• While various hedging strategies exist, it is important to identify assets and approaches with specific characteristics (like convex pay-offs) that are crucial to mitigating tail risks – irrespective of future market conditions

Little seems able to stop the rally in developed market equities seen since October. The S&P 500 closed at an all-time high in February, crossing the 5,000 level for the first time. While there are certainly encouraging signs (resilient earnings, inflation coming down) market expectations for a “no-landing” might be too optimistic. 

Given our base case is for global economic growth to slow this year, what could the combination of strong market performance and bullish sentiment, with the expected headwinds in 2024, mean for portfolio positioning?

Introducing hedging

The primary line of defence for investors when managing risk involves meticulous diversification through a structured investment approach. Creating well-diversified portfolios is a fundamental principle for achieving long-term success and to grow wealth over an extended period.

Getting and staying invested remains the best way for investors to achieve their objectives to protect and grow wealth over the long term. Long-term market performance is tied to growth drivers such as technological progress. Yet markets rarely climb in a straight line, and poorer-than-expected economic data has the potential to hit short-term returns, as pointed out in ‘Capitalising on market psychology’.

In the face of cyclical market fluctuations and heightened uncertainty, portfolio valuations might suffer. For those investors who want to protect against possible downside moves, customised tail-risk hedging could allow for this, while retaining long-term perspective and market exposure, to reap the benefits of being invested. Additionally, these hedges might create opportunities to strategically acquire risk assets during times of market distress, often at discounted prices.

There are always reasons to hesitate

Performance of the S&P 500 since 2009, with selected market-moving events when short-term hedging could allow investors to stay invested for the long term with more confidence

Overcoming reluctance

Protecting against equity-market sell-offs frequently involves a significant risk-return trade-off. Traditional “tail-hedging” strategies rely on equity index options markets, providing downside protection, albeit at a considerable cost. Not only do these strategies exhibit a negative long-term expected return, but their expense tends to escalate precisely when it is most needed. Some investors may recoil from the idea of paying for protection, since the negative events are not guaranteed to occur, while the hedging cost is. 

Optimistic investors may see such strategies as an unnecessary drag on returns, while their more pessimistic peers might simply prefer to reduce their market exposure and mitigate the risk altogether. 

However, timing the market is an extremely difficult sport. Additionally, making emotional investment decisions can introduce biases into the process, which can ultimately act as a drag on returns, as highlighted in ‘Waiting for a tipping point’.

The value of hedging

During periods of market stress, tactical portfolio allocation shifts, implemented through a meticulous security and fund selection process, are helpful when managing  risk-asset exposures. For instance, this could include reallocating towards defensive and low-beta equities, like those in the consumer staples and healthcare sectors as flagged in ‘Playing defensive through quality and pricing power’. 

Alternatively, credit risk might be cut by shifting exposure to debt with higher-credit quality, and increasing allocations to “safe-haven” assets such as government bonds, gold, the US dollar or Japanese yen to enhance portfolio protection. Furthermore, investors might consider adding exposure to uncorrelated alternative strategies such as global macro, trend-following and equity-market neutral, as well as considering direct purchases of put options and various structured derivatives. 

The crux of establishing effective tail-risk hedges lies in mitigating exposure to downside risk while concurrently managing costs. Ideally, a hedging programme should yield more profits in a realised risk scenario than the cost of it. Consequently, seeking a more cost-efficient approach that effectively safeguards against the predominant portfolio risk, typically emanating from equities, is imperative.

Finding robust portfolio protection

Investing in cash or a defensive US equity long-short strategy – being long the S&P 500 Quality Style index and short the S&P 500 Composite index – have most consistently offered robust portfolio protection in quarters when US equities fell by at least 10%, according to our quantitative analysis. These two hedging strategies are closely followed by US Treasuries, the Japanese yen/Australian dollar exchange rate and a derivatives-based overlay strategy as effective ways of protecting wealth.

Additionally, gold and macro hedge funds averaged positive returns during such three-month sell-offs, albeit less consistently (see chart). This underscores the importance of identifying assets and strategies with anticipated convex pay-offs to achieve effective tail-risk protection.

Safe-haven assets and tail-risk hedging strategies typically shelter portfolios in market downturns

The best, worst and average quarterly performance of several safe-haven assets, a defensive long-short equity strategy (long S&P 500 Quality index and short S&P 500 Composite index), global macro and equity-market neutral hedge funds, a put-option overlay strategy (one-month 5% out-of-the-money S&P 500 puts) and the zero-cost put-spread collar strategy (long one-month 2.5-5% S&P 500 put option spread and short out-of-the-money S&P 500 call options) during periods when the S&P 500 lost more than 10% since 2000. Annualised cumulative returns for the full sample (across all market regimes) are reported in the parenthesis on the x-axis

Implementation

There are many ways to hedge portfolio assets. In addition to the strategies discussed above, other potential approaches include products which are structured in such a way as to provide capital protection, while still allowing investors to participate in the upside.  

As demonstrated, there are many cost-effective tail-risk hedging strategies available that can allow their portfolios to remain invested, and diversified, should events spook markets. In turn, such an approach can help investors to weather a variety of macroeconomic environments and grow their wealth over the long term. We advocate for diversification even in the realm of cost-effective tail hedges. 

Equity markets may have started the year in upbeat mood. But with our base case still for the global economy to slow this year, and the timing of anticipated rate cuts already being pushed back, market pullbacks are likely at some point. 

That said, recent US growth and labour-market data has been surprisingly strong. So, if this run of data is sustained, investors may turn out to have been too pessimistic, with implications for portfolio positioning, as flagged in ‘What if the US economy does not land?’ Either way, this year might be a wild ride for investors.

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