Under the Radar: the value of hedged equity in a diversified portfolio

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1 Under the Radar: the value of hedged equity in a diversified portfolio By Emmett Maguire III, CFA Lake Street Advisors, LLC Investment Analyst As hedged equity strategies have underperformed their long only peers for the last one, three, and five years, investors are questioning the validity of a hedged approach to equity investing. Naturally, individual investors are attracted to those asset classes and strategies displaying the most attractive near term results. There are compelling reasons for the inclusion of hedged strategies, however, that go beyond the straight comparison to long only equity. Viewing asset allocation decisions in the context of Modern Portfolio Theory enhances the case for hedging a portion of one s equity exposure. Meanwhile, the simple math associated with recovering from a drawdown and compounding interest strengthens the argument, and biases explained by behavioral finance also support intangible benefits of reducing equity volatility in a portfolio. Hedged equity strategies participate in the flow of equity markets in a more muted fashion, cutting off the extreme highs and (more importantly) the extreme lows. Portfolios benefit from this stabilizing allocation especially when volatility is the global norm and the best way to compound returns over the long term is to dampen volatility, particularly to the downside. Hedged equity builds balance A strong portfolio starts with asset allocation spanning holdings in equity, fixed income, real estate, private equity, and absolute return strategies. As a subset of the equity portion, hedged equity provides an underappreciated aspect of volatility management. Hedged equity strategies are designed to participate

2 2 in the general direction of equity markets. In addition to bottom up security selection, skilled hedged equity managers offer downside protection for the equity allocation and portfolio as a whole by tactically maneuvering net equity exposure, scaling up during periods of market appreciation and drawing back during market depreciation. This translates into lower returns in up markets, but better returns in depreciating markets and a portfolio more likely to achieve its goals over the long term. When viewed in terms of the aggregate portfolio, inclusion of hedged equity improves risk adjusted returns and provides notable diversification benefits by delivering a less correlated return pattern. Relative to the traditional 60% S&P 500 Index/ 40% Barclays US Aggregate Index mix, the addition of a Hedged Equity allocation creates higher annualized long term returns and lower long term annualized standard deviation. This results in a materially better Sharpe Ratio for portfolios. A common rebuttal when discussing the returns in active management in general hinges on the fact that these returns and statistics look less compelling on a post-tax basis, which is true. Subsequently, examining the tax efficiency of strategies in the course of selecting managers becomes an important phase in the process, which is discussed in the next section. In a more direct comparison, hedged equity has more often than not outperformed the S&P 500 over the past 20 years of rolling 5 year periods, indicating that recent history is more the exception than the rule.

3 3 One of the strongest attractions to a hedged equity allocation is that it can help mitigate the emotional decision making that causes individuals to sell into market weakness. Herding behavior, cited in Robert Shiller s Irrational Exuberance, can translate into ineffective and detrimental market timing, as individual investors extrapolate recent performance into expected long term investment results at precisely the wrong time. According to a Dalbar study of actual experienced investor returns, in 2011, a notably volatile year in equity markets, equity mutual fund investors gave up on the markets shortly before the year-end recovery and suffered a loss of 5.73%, compared to a 2.12% gain for the S&P 500. This erodes the long-term gains that began to recover from the devastating losses of I This is a common theme in many Dalbar studies of dollar-weighted investor returns over calendar years and longer periods of time. There are a host of behavioral tendencies coming out of the budding field of behavioral economics that make the case for hedged equity even stronger. Loss aversion, first discussed by Daniel Kahneman and Amos Tversky in Prospect Theory: An Analysis of Decision under Risk, II describes the tendency for people to feel losses more deeply than they do equal gains. For example, when asked if they would rather receive a $25 discount or avoid a $25 surcharge, most respondents preferred to avoid the perceived loss of a surcharge and forgo the discount. In essence though, they are the same degree of price change, just framed as a loss and as a gain. III The poor timing is a direct result of buying high and selling low based on prevailing sentiment, locking in losses when the magnitude of the drawdown in an equity allocation becomes too much to bear emotionally. When executed correctly, a hedged equity allocation can help manage the downside and the associated undue stress. Aside from the psychological and behavioral safeguards, there are mathematical benefits to the moderation of drawdowns associated with a hedged equity allocation. A common misconception among individual investors is that a 15% loss requires a 15% return to get back to par, but that underestimates the impact of lost capital. For example, starting with $1,000,000 in the S&P 500 Index an investor experiences a -15% return

4 4 during the first 6 months of the year. This brings the value of the investment down to $850,000. Earning 15% on the $850,000 during the remaining 6 months of the year will only bring the value of the investment back to $977,500, a shortfall of $22,500. The return required to get back to the original amount of $1,000,000 is actually %. This phenomenon looms larger as the size of the drawdown increases: PHILOSOPHY, PROCESS, AND PEOPLE Close attention should be paid to a manager s investment philosophy (what they believe in) and their investment process (how they implement those beliefs to produce excess returns). It s essential that these qualitative attributes match what the end investor seeks in his/her hedged equity allocation. Further, members of the investment team must be scrutinized to determine their ability to implement the investment process and add value to a strategy s returns. OPERATIONAL STABILITY A well implemented hedged equity allocation can help mitigate excessive drawdowns in an equity allocation by protecting capital in down markets. As a result, a portfolio can compound returns from a larger asset base, putting the power of compounding interest more heavily in an investor s favor. Manager selection completes the puzzle The proliferation of hedge funds IV has made selecting the right manager a difficult task; finding the best fit for a portfolio requires consideration of all the above and a host of additional qualitative and quantitative assessments. Managers must pass through intensive due diligence and should be subject to rigorous ongoing monitoring, including areas such as: In the current climate of intensifying regulation, managers must be at the top of their game when it comes to running the fund and their business. They should pass through due diligence that ensures best in class operations, policies and procedures, including verifying legitimacy of service providers, reference checks and ensuring they have the human capital to handle intensifying regulatory requirements. RELATIVE TAX EFFICIENCY This is a true test of managers, as most hedge fund vehicles are constructed for a high volume of trades and can be tax inefficient compared to passive long only strategies. Managers that will fit into a broader portfolio ideally exhibit a lower turnover rate/longer holding period, ability to harvest losses where applicable, and trade implementation accounting for tax implications (trades falling under Section 1256 for example). However, the burden also falls on asset location. If hedged equities can be placed in certain entities or tax efficient vehicles such as IRAs, it can help offset tax exposure. This is all part of a comprehensive tax and estate strategy.

5 5 TRACK RECORD AND MARKET EXPOSURE ADJUSTED ALPHA Managers that fit the profile of hedged equity will have exhibited downside protection in negative markets and upside participation in appreciating markets. In particular, managers must mitigate drawdowns relative to long only equity indices. This is accomplished by having less than 100% net equity market exposure (net exposure = long exposure short exposure). Additionally, managers should have returns in excess of an appropriate index, adjusted for the manager s net market exposure. For example, the S&P 500 Index returned +8.2% annualized for the last 20 years. Manager XYZ has an average net exposure of 60%. The S&P return adjusted for 60% net exposure is +4.9%. If Manager XYZ is in fact a skilled stock picker, the return should be in excess of +4.9%, indicating positive alpha generation. Portfolio management is a thoughtful, complex and dynamic process that factors in a range of considerations both personal and pragmatic. Investors must combine a number of strategies to address their long term goals, and the right hedged equity manager can play an important role in a diversified approach that limits downside during volatile times. By viewing the portfolio as a whole, combining various strategies in a tailored and strategic fashion, investors can maximize their return per unit of risk and create a portfolio built to meet long term objectives. Endnotes I II III Investor fear leads to losses in 2011, Press Release, Dalbar, March 19, 2012 Prospect theory: an analysis of decision under risk, Daniel Kahneman and Amos Tversky, March 1979 Choices, Values, and Frames, Daniel Kahneman and Amos Tversky, Cambridge University Press, 2000 {adapted examples] IV Hedge funds launches surged in 2011, Katya Wachtel, Reuters, March 13, 2012 Copyright 2012 Lake Street Advisors, LLC. All Rights Reserved. Information on this paper is directed toward U.S. residents only. Lake Street Advisors, LLC only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. Lake Street Advisors, LLC, is not engaged in the practice of law or accounting. Information contained herein or attached should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation. Any tax advice in this document was not intended or written to be used, and it cannot be used for the purpose of avoiding tax penalties pursuant to IRS Circular 230.