With the myriad of different products and strategies related to investing, there’s plenty that investors may not be aware of. One example would be hedged equity. While most investors will know what hedging and equities are, we sat down with Swan Global Investments, creators of the Swan Hedged Equity US Large Cap ETF (HEGD), to learn more about what exactly Hedged Equity together means. Built upon a process launched in 1997, the Swan Hedged Equity US Large Cap ETF (HEGD) seeks long-term capital appreciation while mitigating overall market risk.
Positivly: So what, really, is hedged equity?
Swan: First, let’s understand hedging. Hedging has been around a long time. Farmers, airlines, banks – they all hedge to manage the biggest risks in their businesses. Farmers hedge against changes in seed, livestock and crop prices. Airlines hedge against big changes in oil prices. Banks hedge against interest rate risk. If you own car or home insurance, you are essentially hedging against potential property loss either due to a car accident or housing catastrophe.
Diversifying your portfolio can sometimes appear like a form of hedging. In its most simple form, our take on hedged equity is through a distinct blend of passive equity investing and active risk management. We chose this approach with the goal of growth combined with the ability to hedge against losses.
Positivly: When people hear “hedge,” they may start getting some ideas about hedge funds. Are the two related?
Swan: Hedging in this way does not equal anything related to a hedge fund. Typically, you hedge to reduce the negative impacts of market risk and volatility in a portfolio. The hedge is intended to offset potential losses by transferring risk in various ways (e.g. options, shorting, or futures contracts). In our case, we actively manage options trades to help offset the hedging cost.
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Positivly: You use put options, why?
Swan: We believe that put options are much more effective in managing and reducing risk than other forms of hedging. They offer control over the hedging process, are inversely correlated to the asset they seek to protect, may reduce adverse investor behavior, and offer profit potential. Inversely correlated means, the value of the put option will move in the opposite direction as the underlying investment – providing true diversification. During times of major market stress, many investments that investors assume offer diversification actually move in the same direction. Not so with put options.
Some folks may shy away from mutual funds or other investments that use options due to unfamiliarity with options or their capabilities. Hedging, however, offers a direct way to address market risk. A hedged equity approach defines and manages risk through put options may be beneficial for investors who want to remain invested, reduce overall portfolio risk, or seek protection in times of major market stress.
Positivly: How does a hedged equity strategy fit within a portfolio?
Swan: It can serve as a complement to core equity positions to mitigate risk within an overall equity portfolio. Another idea is it could replace low-yielding treasuries or even high-yield corporate or multisector bonds. Finally, it could also be an alternative for investments in commodities, real estate or alternatives. Our goal is to do the hard part (hedging) and provide investors access through a straightforward ETF package.
Positivly: What types of markets is a hedged equity strategy likely to perform most favorably?
Swan: As hedging is meant to reduce risk and volatility, the goal is to lose less money in your investments, especially during times of major market stress. If your portfolio spends less time recovering, it may spend more time compounding.
Having said that, our differentiator is that we look at hedging as a long-term solution though market cycles. Many investors and advisors are semi-programmed to think of buying or selling investments based on timing and market conditions, of course. But it’s important to note that our philosophy is always invested, always hedged as a long-term strategy. Our approach is one that investors can buy and hold, yet is designed to be less volatile than buying and holding equities alone. Wall Street and the media, not to mention most strategies, approach hedging as a short-term solution or tool that invites timing risk. It is our belief that hedged equity is not something to buy only when the markets look ominous, and sell if things look better ahead.
Definitions (Source: Investopedia)
Passive Investing: Passive investing broadly refers to investment strategies with minimal trading. Index investing may be the most common form of passive investing, where investors seek to replicate and hold a broad market index.
Options: Options are financial derivatives that give the buyer the right to buy or sell an underlying asset at a stated price within a specified period.
Put Option: A contract giving the option buyer the right, but not the obligation, to sell a specified amount of an underlying security at a predetermined price within a specified time frame.
Shorting or Short Selling: Short selling is an advanced investment or trading strategy that speculates on the decline in a stock or other security’s price.
Futures Contract: A legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future.
Volatility: A statistical measure of the dispersion of returns for a given security or market index. In most cases, the higher the volatility, the riskier the security.