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 asset classes and strategies that display 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.

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.

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 the intangible benefits of reducing equity volatility in a portfolio.

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 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 500/40% Barclays U.S. 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 active management returns is that returns and statistics look less compelling after taxes, which is true. Subsequently, examining the tax efficiency of strategies in the course of selecting managers becomes an important phase in the process.

In a more direct comparison, hedged equity has more often than not outperformed the S&P 500 over the past 20 years of rolling five-year periods, indicating that recent history is more the exception than the rule.

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 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 with a 2.12% gain for the S&P 500. This erodes the long-term gains that began to recover from the devastating losses of 2008.” 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 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, 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.

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. 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 million in the S&P 500 index, an investor experiences a 15% loss during the first six months of the year. This brings the value of the investment down to $850,000. Earning 15% on the $850,000 during the remaining six 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 million is actually 17.65%.

This phenomenon looms larger as the size of the drawdown increases [see Figure 3].

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.

The proliferation of hedge funds has made the selection of 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 the following areas:

Philosophy, Process And People
Close attention should be paid to the investment philosophy  managers believe in and how they implement those beliefs to produce excess returns. It’s essential that these qualitative attributes match what the end investor seeks in his or her hedged equity allocation. Moreover, 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
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—by verifying the legitimacy of service providers, making 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 more tax inefficient than passive long-only strategies. Managers that will fit into a broader portfolio ideally exhibit a longer holding period and the ability to harvest losses and conduct 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.

Track Record And Alpha
Managers whose style fits 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 equals long exposure minus 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 returns 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% annualized returns.  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.

Emmett Maguire III, CFA, is an investment analyst with Lake Street Advisors LLC.