By Donald Ingham
There are times where certain
tools in investing can be expected to work better than others.
Hedging equity exposure is one of those tools where the
cost/benefit can vary substantially over time. Given that
long/short equity is once again in vogue as a popular hedge
fund strategy, and the S&P 500 continues to make record
highs, this is a topic that merits discussion.
Over very long periods of time,
there is an expected cost to reduce volatility through hedging,
as investors who hedge are capping the upside of fractional
ownership of profitable businesses. However, in intermediate
time horizons there are periods where hedging equity exposure
can be expected to not be a drag on performance, or can even be
a tail wind. We will take a blunt look at how the combination
of valuation and short rebate interact to give us an idea of
how hedging might impact returns.
In effect, shorting out market
exposure means the hedge portion of the portfolio gets paid
short-term interest rates through the short rebate as well as
any stock market downside. When market participants talk about
hedging, often they discuss how the market is going to perform
over a period of time rather than the current short rebate.
They emphasize market direction despite the short rebate being
as important - if not more important - and far more predictable
over the short term. Why is this? In order to compensate for a
4% rebate going to zero on a fully hedged portfolio, alpha has
to increase 4% per year to be net neutral to performance.
For simplicity, take a look at
the Federal Funds rate. Hedge funds usually receive less, but
this works for our exercise. Managers often underestimate the
importance of the level of short rebate when evaluating the
prospective likely returns for low net long/short strategies.
In addition to being very important and often making up as much
as half the total expected return for the strategies, the short
rebate is much more knowable over a shorter-term horizon.
Another benefit of focusing on
the short rebate is that the Federal Funds rate is usually
being increased well into a bull market and decreased as the
market is well into a decline, providing the sweet spot of both
a reasonable short rebate and overvaluation. This provides
additional support for paying attention to both valuations and
the short rebate when considering the amount of equity exposure
fund managers would like in their portfolios.
Below is a chart of the Federal
Funds rate as a proxy for the short rebate from 2000-2013:
On the long side, the formula for
forecasting returns for an operating business is:
Total Equity Return
= Dividends + Increases in Earnings/Cash Flow + Multiple
Overall market returns can also
be forecast in a similar manner. None of them are perfect, but
here is one perceived by other experts to be reasonably
Let us estimate the 10-year
return of the S&P 500 by combining three components: 6%
growth in fundamentals, reversion in the Shiller P/E toward 15
over a 10-year period plus the dividend yield. For a simple
model it has a correlation of more than 80% with actual
subsequent 10-year returns.
10-Year Total Return
Estimate = 1.06 * (15/Shiller PE)*1/10 -1 + Dividend Yield
The chart below illustrates the expected ten year annualized
return of the S&P 500 monthly from January 2000 until the
end of the third quarter 2013:
Putting it all
With the short rebate and
expected annualized return now clear, the net expected
cost/benefit of running a fully hedged portfolio is shown in
the chart below. When the line is above zero, the combination
of overvaluation and the short rebate indicate a positive
benefit from being hedged. When the line is below zero, there
is an expected annual drag.
While past performance is not
indicative of the future, because of extreme overvaluation and
an acceptable short rebate, hedged investors were actually
expected to receive a substantial benefit of being hedged in
January of 2000. In early 2000, with data available at the
time, the tail wind from running a fully hedged portfolio
peaked at around 10% annualized with a Fed Funds rate at 6.5%
and an expected equity return of -3.5%. Conversely in early
2009 the opposite was true, where there was an expected equity
return of over 10% and a 0% effective short rebate. These two
extremes occurred within 10 years of each other and were far
enough away from the norm that they should merit
Based on this exercise, investors
should use the above framework when thinking about intermediate
time horizons in order to get a reasonable idea what they are
gaining or giving up by choosing their level of net exposure
across their equity portfolio. Anything can happen in the short
term, but as extremes are approached either in favor of or
against hedging, managers can use this simple calculation to
adjust their portfolios accordingly.
Ingham is a director of Tenth
Avenue Holdings in New York and portfolio manager of the
TAH Core Fund.