Hedging

Hedging is a strategy that seeks to preserve gains or mitigate losses on investments.

It involves entering a new investment aimed at offsetting changes in the price of an existing investment.

So, if an existing investment rises or falls in price, the new investment may do the opposite in each case.

Any gain or loss on the hedge may help keep the value of the original position more stable.

It isn’t just investors who use hedges, of course.

Agricultural producers have, for centuries, used hedging to try and fix the price they receive for a future harvest.

Likewise, companies selling overseas often try to lock in the exchange rate they will get.

While hedging may sound like an appealing concept, it is important to stress that hedging strategies are only suitable for certain investors.

 

How does hedging work?

 

Let’s look at a simplified example of a hedge in action.

An investor owns a position linked to an equity index.

They are concerned that the index could suffer a 20% loss in the next six months.

Still, the investor doesn’t want to sell, as they believe the medium-term outlook is good.

Also, selling might incur capital gains taxes, as the investor bought some years ago at a lower price.

Instead, they enter a strategy that could potentially pay a return equal to any fall in the index over the next six months.

If they are right and the index falls 20%, they can receive a return on the hedge which helps mitigate the loss on their original position.

If they are wrong and the index goes up, they lose the cost of the hedge but have still made a positive return on their original position. 

However, the net outcome may be a loss if the cost of the hedge is greater than the return.

The cost of entering a hedge will depend on a variety of things, including which strategy and instruments are involved, how long it lasts, what market it is hedging against and interest rates.

 

Hedging in portfolios

 

Hedging strategies are neither suitable for all investors nor necessary.

For suitable investors, however, it may be possible to hedge many kinds of assets.

These include equities, bonds, commodities and foreign exchange.

Over the long term, the cost of hedging mounts up, eroding portfolio returns.

However, hedging strategies may assist suitable investors in certain situations.

Take an investor owning a large position in an equity that they wish to sell. However, they are unable to do so for a few months, perhaps for contractual reasons.

To try and preserve the value of their position until then, a hedge could help mitigate the effects of any fall in the share price.

However, there is a kind of hedging that may be suitable for many investors: diversification. That is the natural effect of building a global portfolio across asset classes.

By combining equities, fixed income, cash and other asset classes in carefully calculated proportions, some investors over time have dampened the effects of market turmoil on their portfolios.

During big selloffs in global equities, the highest quality bonds from governments like the US have often risen.

Gains on bond holdings have thus sometimes helped offset losses on equities and other risk assets. 

 

The risks of hedging

 

Hedging seeks to mitigate the risks of investments. However, it also comes with risks of its own.

There is no guarantee that a hedging strategy will work. A worst-case scenario could see both the hedge and the position it is meant to hedge lose money at the same time.

Another risk is that the party selling the hedge goes into financial distress and can’t hold up its end of the deal. So, even if a hedge would have made money, the buyer of the strategy loses out.

As we’ve seen, hedging can be costly, incurring transaction fees, for example. It also requires time and monitoring. 

Even if a hedge makes money, its costs will eat into the return.

 

The bottom line

 

Hedging can be useful for suitable investors with specific needs but comes with risks of its own.

For  investors, the natural hedging that can potentially come from a long-term, well-diversified portfolio is sufficient.

There is never a guarantee that a hedging strategy will work.

KEY TAKEAWAYS:

 

Hedging is a strategy for suitable investors only that seeks to mitigate losses and preserve value of an existing investment.


The basic principle is buying something whose price may move in the opposite direction to the existing investment.


Gains or losses on the hedge may help offset losses or gains on the existing investment.


Hedging strategies incur transaction fees, which accumulate over time,so hedging is may only be appropriate in short-term scenarios.


A hedge can also fail if the party providing the hedge enters financial distress


There is no guarantee that a hedging strategy will work