The ChoosaBroker Trading Academy
Hedging is a portfolio management tool that every investor should be aware of. There is no arguing that protecting your investments against the numerous manners of risks is often just as important as portfolio growth. Widely considered an advanced strategy, the underlying principles of hedging are however relatively straight-forward, rendering them accessible even to the average, retail investor. In this lesson, we will learn about:
Who is a Hedger?
Any investor who seeks to reduce his or her portfolio risk by the sale or purchase of additional financial assets is known as a hedger. The most common way by which investors reduce their market risk is by making use of derivative instruments like futures and options to take up positions that are opposite to the risk they are otherwise exposed to. Let us look at a typical example to better understand the process.
Commercial farmers are frequent hedgers. Suppose, during a particular season, a farmer decides that growing wheat would be a lucrative proposition. Once he plants the crop, he is committed to it for the entire season. In case the market price of wheat appreciates greatly between the sowing and the harvesting period, the farmer would stand to make an unexpected profit. On the contrary, if the actual market price were to decline by harvest time, the farmer would be at a risk of suffering a loss. To overcome this uncertainty of future demand-supply dynamics playing havoc with his farm income, the farmer may decide to sell futures contract on wheat at the time of sowing. Futures contracts are mutual agreements to deliver a specified quantity of the commodity at a pre-determined date for a fixed price. If the farmer sells a number of futures contracts equivalent to the amount of wheat he anticipates to harvest, he would have essentially guaranteed a certain number of bushels for a certain price, thereby reducing the likelihood of any surprise dip in market price eroding his profits.
Types of Financial Hedging
One of the common misnomers about hedging is that it is a time-consuming, costly and complicated process. That is not always accurate. At the end of the day, there are three broad types of hedges: perfect hedges, partial hedges and cross hedges.
- Perfect Hedge A perfect hedge is said to have been created by an investor if nearly every aspect of market risk is eliminated from the portfolio. In order to build a perfect hedge, an investor has to initiate a new position that would bear a 100% inverse correlation to the existing position. A popular example of an almost-perfect hedge is when a market participant uses a combination of a long position in a common stock and opposing put contracts with the same underlying stock to self-insure against depreciation in market value.
- Partial Hedge As the name implies, a partially hedged portfolio is one that has both long and short contracts of the same asset, but with differing position sizes. This may be the direct outcome of a trader’s perception of the market risk involved in any specific trade. For example, if an investor reckons that the equity market sentiment is bearish, but not downbeat enough to warrant taking a naked short position, he or she may simply decide to partially hedge the short position by buying a call option that might be 50% in value of the open short position.
- Cross Hedge A cross hedge is said to have been formed when an investor takes opposing positions in two positively correlated assets. The success of any cross-hedging strategy is primarily reliant on how strongly correlated the two assets are. One notable feature is that when using a cross hedge, the maturity of the two assets must be similar. In other words, an investor cannot cross-hedge a long-term security with a short-term instrument.
Different Hedging Strategies
Hedging is the practice of buying and holding financial assets with the view to lessening the risk in an existing portfolio. These assets are ideally intended to move in a direction opposite to the rest of the portfolio’s securities. When done properly, hedging significantly reduces the element of uncertainty in a portfolio. Let us examine four such simple hedging strategies:
- Hedging Against Market Volatility The big risk that everybody wants to shield against is market volatility. The key is to include assets that are not correlated over a prolonged time-frame. A well-diversified portfolio is one that comprises of diverse bonds and equities of all ilk: small, mid and large-cap; growth, value and dividend-paying; international and emerging markets. A solid cash allocation is also a proven strategy to lower volatility.
- Hedging Against Credit Risk The easiest way to hedge against “credit risk” is to always have a mix of U.S. Treasuries and other highly-rated sovereign debt in a portfolio. Corporate bonds of large multinationals with strong balance-sheets are another widely-utilized route to decrease the risk of default.
- Hedging Against Risk of Inflation Any asset that protects an investor against the risk of a fall in the real value of money is known as an inflation hedge. Such assets typically exhibit their own intrinsic values. Examples of hard assets include crude oil, gold, natural gas and to a lesser extent, commercial real estate. Most hard assets are excellent hedge against inflation. They tend to appreciate during periods of negative real interest rates, when equities and bonds generally fare poorly.
- Hedging Against Risk of Liquidity The risk that a financial asset might not trade quickly enough in the market without pronounced price change is referred to as liquidity risk. To avoid this unlucky plight of not being able to sell your holding or be compelled to do so at a distressed price, investors should always allocate a certain portion of their portfolios to short-maturity Treasuries. Thereby, in case of any emergency need for cash, he or she will always have a cushion to fall back on.
How Do Hedge Funds Work?
A “hedge fund” is a fancy name for an investment partnership. The term “hedge”, which depicts a boundary of bushes around a field, is used as a metaphor in this context to represent the practice of placing curbs on risk. Early hedge funds strived to hedge their long investments against the risk of adverse market movement by actively shorting other instruments.
Key Characteristics of Hedge Funds
- Open only to “accredited” investors: Individual investors in hedge funds generally need to satisfy certain net worth stipulations. In the U.S., only individuals, whose net worth exceeds $1 million, qualify to invest in hedge funds.
- Broad investment flexibility: A hedge fund’s investable asset universe is relatively large. It can invest in stocks, bonds, commodities, currencies and real estate. Mutual funds, in comparison, have to primarily stick to stocks and bonds.
- Leverage at play: Hedge funds often employ leverage, or money borrowed from others, to augment their returns.
- Fee structure: The most common hedge fund fee break-up is known as “Two and Twenty” – a 2% fund management charge, on top of a 20% share of profits.
A Fictional Example of a Hedge Fund in Operation
To better understand how hedge funds work, let us set one up and track it for one full year. We shall call it “Growth Fund, LLC.” The operating agreement states that the fund manager will collect 20% of the profits in case they exceed 5% each year, and that she can trade and invest in anything from any place in the globe.
Twenty investors commit, each putting in $5 million, taking the total asset under management to $100 million. Each of these twenty investors fill out an investment agreement and wire the money directly to the fund administrator, who does all the administrative work for the asset management company. Growth Fund is now open, and the fund manager starts looking for attractive investments. She finds five, calls the fund’s broker and instructs to buy assets worth the entire $100 million.
A year passes by and the hedge fund appreciates by 60%, taking its value to $160 million. According to the operating agreement, the first 5% belongs solely to the investors, with anything above that being divided 20-80 between the manager and the investors. As such, the capital gain of $60 million would first be deducted by $3 million, or 5% of $60 million, and would go to the twenty investors. That 5% is also known as the “hurdle rate,” because the investment manager has to first cross that 5% return threshold before pocketing any performance incentive. The remaining $57 million is split; 20% to the manager and 80% to the twenty investors.
Based on the performance during the first-year and the terms of the hedge fund, the fund manager would have earned $11.40 million in remuneration, with the twenty investors netting the remaining $45.60 million, on top of the $3 million initial hurdle rate, for a total capital gain of $48.60 million. As is evident from the above example, the hedge fund venture has the potential to generate big returns. If the manager were to instead handle $1 billion, her take would have been $114 million and the investors, $486 million. Many hedge fund managers get crucified for earning such copious amounts of money. But that’s because the financial press that does most of the finger pointing conveniently fails to notice that the investors also made a whopping $486 million!
Hedging is purely about decreasing or transferring your risk. It is a valid strategy that can help protect not just you investment portfolio, but also your home and business from the uncertainties that seem to lurk at every corner.