Hedged equity without the onerous hedge fund fees.
This is part of a regular series of thought-leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by Hafeez Esmail, San Francisco-based Main Management’s director of marketing.
As the U.S. market grinds along in June. there appears to be a broad spectrum of opinions about its direction going forward. There are those who feel we’ve had five years of a bull market and therefore a significant pullback must be around the corner.
Most would agree that valuations are probably not cheap, but are they at rich levels that warrant a sizable correction? Others feel that the U.S. is still the most appealing option in a global economy universally plagued by a variety of ills. For all—other than those who feel the market is a screaming buy at current levels—it may be worth considering hedging at least a portion of client portfolios.
Typically, when the term “hedging” is bandied about, it conjures up thoughts of a costly 2 and 20 fund structure. Of late, hedge funds have also been associated with underperformance as the industry as a whole has struggled to justify the steep fee structure particularly over the past three years.
The HFRX Equity Hedge Index returned -19.08 percent in 2011, 4.81 percent in 2012 and 11.14 percent in 2013, and thus has a negative compounded annual growth rate over that stretch. Moreover, there is the absence of liquidity, which further dims the appeal of this option. In addition, there is rarely clear insight into the underlying holdings of these funds. Accordingly, a viable alternative would address liquidity, transparency and performance.
Option writing as a hedging strategy has historically had mixed reviews. Part of this reputation comes from strategies that write covered calls on a portfolio of single stocks. What tended to happen is that the high-flying stocks got called away and what remained is a portfolio of underperformers. However, when writing calls on a broader basket of stocks (such as the S&P 500), one avoids the “adverse selection” that occurs with individual positions.
In the near term, covered option writing tends to outperform broader markets where markets are flat or lower, as the option premiums are typically captured and are thus accretive to portfolio returns.