The true cost of hedging

Wed Mar 5, 2014

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A framework for determining net exposure in an equity portfolio.

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.

Short Rebate Level

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:

Valuation Level

On the long side, the formula for forecasting returns for an operating business is:

Total Equity Return = Dividends + Increases in Earnings/Cash Flow + Multiple Expansion/Contraction

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 accurate.

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 (Decimal)

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 together

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 attention.

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.

Donald Ingham is a director of Tenth Avenue Holdings in New York and portfolio manager of the TAH Core Fund.

ISSN: 2151-1845 / CDC10004H

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