White Paper
Hedging Equity Portfolio Risk: Three Drivers to Consider
Hedging a portfolio is a difficult task; it requires investors to know when to execute a hedge,
what asset to use, and when to remove the hedge. Hedging is typically used to mitigate risk,
but it carries the risk of missing further price appreciation. To properly hedge, investors need to
have a process in place to determine why they are hedging (too often the driver is emotion) and
how to best execute the hedge.
In this paper, we take a look at three basic drivers behind market downturns, the dynamics
unique to each, and the tools to consider when one or all three drivers are in play. Hedging can
be sophisticated and complex, and the discussion below is provided for educational purposes
only — not as investment advice. Investors should always discuss investment strategies with
their financial advisor before making a decision.
Driver No. 1 – Valuation
Valuation by its nature is subjective; it is based on expectations for growth and assumptions
about interest rates. Small changes in either factor can cause large changes in the final
valuation number. The drawback to using valuation as a timing tool for hedging is that at some
point in history, each of the six common valuation ratios described below has said the market
was overvalued — and then the market rallied far beyond its “overvalued” levels. For this reason,
valuation is the least reliable of the three drivers for timing a hedge, but it can be valuable for
determining whether to rebalance a portfolio.
Six Common Ways to Evaluate Valuation
There are many ways to make judgments about market value, and below is a list of the more
popular methods. A word of caution: just because they are popular doesn’t mean they are
infallible. However, looking at these metrics in aggregate is helpful because they all use different
factors to determine value.
•
Market-forward-price-to-earnings (PE) ratio: This ratio takes the current market price
and divides it by analyst expectations of where earnings will be one year from now. The
obvious issue with this method is that analysts are rarely accurate. But many people like
this ratio because it takes into account future expectations.
•
Market-price-to-earnings ratio: This looks at current market price and divides it by the
current earnings on the index. On the plus side, it doesn’t use analyst estimates, which
means it won’t look “cheap” at market tops. However, earnings don’t always give the full
picture as companies can use different gimmicks to inflate earnings value. (If you’d like to
explore this topic in more detail, Howard Shilit’s classic book “Financial Shenanigans” offers
more information.)1
•
Cyclically adjusted price-to-earnings ratio (CAPE): Similar to the above, but it uses 10year average inflation-adjusted earnings. This ratio smoothed out the volatility, which is good,
but because it looks back over 10 years, extremely good or bad years can skew the data.
•
Q-Ratio: This ratio divides the market cap for the whole S&P 500 Index by the total value
of its assets. A reading below one implies that investors can buy the stock for less than
replacement value, meaning that it’s undervalued. Readings above one imply the stock is
overvalued. If you’d like to learn more about the Q-Ratio, a post on advisorperspectives.com2
includes a more in depth explanation of how this ratio works.
•
US total-market-cap-to-GDP ratio: This ratio was made popular by Warren Buffett. It
takes the total market capitalization of the Wilshire 5000 Total Market Index and divides
it by the total gross domestic product (GDP) of the US. A reading above one suggests an
overvalued market. A reading below 0.6 implies an undervalued market. Those are loose
guidelines; in theory the market shouldn’t trade much above the nation’s GDP. The issue
with this indicator is as the market becomes more global, US GDP doesn’t fully encompass
all business being transacted by US companies.
•
Price-to-sales ratio: The price-to-sales ratio of the whole market looks at the top line
(revenues) and ignores the rest. Revenue is hard to manipulate, so in my view this is a
cleaner look at corporate growth. Similar to PE and CAPE, determining if valuations are
high or low is based on relative value to past levels. Price-to-sales is defined as the market
price per share divided by revenue per share.
Please see the back page for terms and definitions.
1 Schilit, H. and Perler, J. (2010) Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, 3rd Edition. The McGraw-Hill
Companies. Most recent data available.
2 Doug Short, May 6, 2014,The Q Ratio and Market Valuation: Monthly Update. Most recent data available.
Not FDIC Insured | May Lose Value | No Bank Guarantee
Three Moves to Consider in Overvalued Markets
No matter which ratio investors use to evaluate the markets, there are three moves to consider
if they feel the market is overvalued. (As always, talk to your financial advisor before making
any changes to your portfolio strategy.)
•
Sector rotation: In this strategy, investors sell out of sectors that traditionally expand
during economic growth periods like consumer discretionary, industrials and technology,
and they but “defensive” sectors like consumer staples, utilities and health care. Be careful,
however, because even defensive sectors can become overvalued and may not provide
defense anymore.
•
Defensive smart beta: Two types of funds fall in this category: those that hedge their
equity holdings with derivatives, and those designed to mitigate risk based on the
underlying attributes of the stocks they buy, such as stocks with low volatility or high
quality. Beta is a measure of risk representing how a security is expected to respond to
general market movements. For example a beta of one means that the security is expected
to move with the market. A beta of less than one means the security is expected to be
less volatile than the overall market. Betas greater than one are expected to exhibit more
volatility or movement than the general market. Smart beta represents an alternative and
selection index-based methodology that may outperform a benchmark or reduce portfolio
risk, or both in active or passive vehicles. Please be aware that smart beta funds may
underperform cap-weighted benchmarks and increase portfolio risk.
•
Undervalued international equities: Historically, global equities tend to be correlated to
US equities during market corrections. However, if valuation is the only issue, then pulling
money out of expensive US equities to buy undervalued foreign equities may be a viable
option. (But make sure they are actually undervalued.) Correlations may be lower and, if
the global stocks are undervalued, they may potentially outperform US equities.
Final Thoughts on Valuation
Valuations are expectations-based. Personally, we don’t try to come up with a specific value
for any stock or market index. Instead, we think of ranges. This is due to the subjective nature
of the valuation process. Investors may want to think about what levels they would view as
extreme before they invest and then monitor many different valuation methods to get a broad
scope of valuation. Have a plan in place with your financial advisor regarding when you will
check valuations, what metrics you will use, and where you may reallocate your resources
should you find stocks expensive.
Driver No. 2 — Event risk
We think the best example of “out of the blue” event risk in my career was the 9/11 terrorist
attacks. The failures of Enron and Long-Term Capital Management are also good examples of
events that caught people by surprise. Event risk is tricky to navigate when hedging a portfolio
because investors can fall prey to two behavioral biases that can hurt our performance.
•
The first bias is recency effect, which occurs when investors are overly influenced by recent
events versus those that are further in the past. Because of the volatility experienced
in 2001, 2008, 2010 and 2011, for example, many investors today expect volatility
to be “normal.” But investors in the bull market of the 1980s and 1990s thought that
environment was “normal”also. The challenge is to respect present trends while not
blowing them out of proportion. It is also important to remember that large events tend
to take time to play out. For example, the housing market peaked in 2005. Yet if we asked
investors when the “housing crisis” occurred, many would likely say 2008. It is important
to take current event risk in context with market price or liquidity extremes. These can take
time to play out, and it is important to stay informed about a previous event even after it
seems complete. The ability to not overestimate an event’s effect is important, but it can
also lead to the second behavioral bias.
•
The second battle investors fight within themselves is the “empathy gap” that is laid out
by James Montier in “Behavioural Investing: A Practitioners Guide to Applying Behavioural
Finance.” An empathy gap is when we underestimate the effects of our emotions on our
decisions. So, investors may sit here today and assume that if an event occurs, we will
make certain decisions. But then, when that event actually takes place, investors end up
making very different choices. “I won’t chase returns,” “I’ll cut my losses,” “I’ll rebalance
my positions,” and so on. When a negative event does become a reality, it is very easy to
get caught up in the emotion of the markets and media. When that occurs, investors start
reacting, lose discipline, ignore processes and go with the crowd. Emotion can cause an
investor to turn a bad situation into a painful one.
Please see the back page for terms and definitions.
2
Three Moves to Consider in Overvalued Markets
No matter which ratio investors use to evaluate the markets, there are three moves to consider
if they feel the market is overvalued. (As always, talk to your financial advisor before making any
changes to your portfolio strategy.)
Monitoring Event Risk
Hedging around event risk hinges on an investor’s process and the long-term investment plan that
was crafted with his or her financial advisor. As challenging as event risk can be, there are certain
disciplines and products that can help manage the risk and the emotions that come with the risk.
We find it helpful to keep a list by geographical region of various potential risks. Then we look at
various markets (equity, sector, fixed income, currency and commodity) and look for long-term
extreme price moves that have occurred in the past. Investors who do this should then talk to their
advisor about the risks of these scenarios to a portfolio. For example, what if extreme prices revert
back to the historically average observed price level? Discuss what triggers could cause the worstcase scenarios to play out. Finally, investors who make such a list should become as educated as
they can about the various items on the list, learn about the arguments for both sides, and discuss
them with their advisors.
To give investors an idea of what this might look like, we made a list of current events below.
The reason for this process is that it will put the various risks in proper context so that investors
are less likely to overestimate the impact, but at the same time they will have an idea (scenario
analysis) of how bad things could get. This process allows investors to put a flexible plan in
place to deal with the event.
Example of Event Risk Thought Process
Risk Type
Time Horizon
Rates rising
faster than
expected
Economic
8–16 months
Geopolitical risk
Geopolitical
24 months
Possible Triggers
to Watch
Possible
Assets Affected
Probability
US
Federal Reserve
Rate Increase
Rising 5-yr Treasury
breakevens
Rising Initial Jobless Claims
Declining US Labor
Diffusion Index
Fixed Rate Bonds
2–20yr duration
bonds
Equities
High Yield Bonds
Medium
Low/Medium
International Markets
Chinese
Deleveraging
Economic
6–12 Months
Impeachment
of Brazilian
President
Geopolitical
6–18 months
Increased defaults,
rising repo rates
Widening credit
spreads in China
Weakness in Brazilian real,
Rising credit spreads
Declining manufacturing
and confidence indicators
Asian equities
Emerging Debt
Currency
High yield bonds
High
Medium/
high
For illustrative purposes only.
Hedging Event Risk
In this piece, we are looking only at hedging event risk and are assuming that fundamentals
haven’t broken down and valuations are fair. By nature, event risk would not lead investors to
aggressively change their portfolio unless the event would directly impact the portfolio. For
example, the issue of China's governments decisions to deleverage will impact commodity
markets, Chinese equities and likely the equity markets of their trading partners. In this
situation investors may want to consider adjusting their weights to Chinese equities as well as
Australian, South Korean, and Japanese equities. Because these events may not play out when
expected or by the magnitude expected, cheap short-term protection is preferable. There are
three sources of protection that fit this description.
•
Index options on the S&P 500 Index or other stock indexes that are traded at the Chicago
Board Options Exchange (CBOE).
•
Options on broad market exchange-traded funds (ETFs) as well as options on single equity names.
•
Options and futures on the VIX Index, which measures implied volatility on the S&P 500 Index
and is negatively correlated to equity markets.
Please see the back page for terms and definitions.
3
The benefit of using options is their cost is fixed. Investors can only lose the premium
paid, much like insurance. Investors can also tailor their time horizon as well as their price
expectations depending on the option purchased. Just remember that the higher volatility
moves, the more expensive that option will become. In this case, VIX futures may be a better
alternative, but they too can be volatile and are more difficult to manage from a sizing
standpoint than options. Because of options’ relatively cheap cost, defined time horizon, and
liquidity, some of the emotion can be taken out of the situation. The tactical nature of options
and VIX futures may help investors navigate event risk with confidence
If you’d like to explore options or the VIX in more detail, Chicago Board of Options Exchange
(CBOE) Institute is a comprehensive resource for those new to options or VIX futures.
Driver No. 3 — Fundamentals
The stock market and the economy are different animals. Fundamentals speak to the health of
the economy whereas the stock market is an imperfect guide to the value of the economy. We
feel utilizing fundamentals as a guide for hedging poses two issues.
The first issue is that fundamentals don’t have to be bad for stocks to go down. The graphic
below shows my proprietary “US Fundamental Health” indicator in dark orange with the S&P
500 Index in light orange. A reading below zero (on the right-hand scale) implies economic
contraction, and a reading above zero implies economic expansion. As you can see in 2010 and
2011, the economy was healing, yet the stock market experienced volatile contractions (two
event risks). Thus the importance of the first two drivers, valuation and events.
In 2010 and 2011, the S&P 500 Index Contracted By at Least 15% While the Economy Was Healing
3000
S&P 500 Index
US Economic Health Indicator
20.00
15.00
2500
S&P 500 Index
5.00
1500
0.00
-5.00
1000
-10.00
500
Positive Fundamentals
15+% contractions in
the S&P 500
US Economic Health Indicator
10.00
2000
-15.00
0
-20.00
1999
2001
2003
2005
2007
2009
2011
2013
2015
2017
Sources: Bloomberg L.P., and PowerShares by Invesco, as of May 31, 2017. US Fundamentals represents the US economy. Past performance is not indicative of
future results. An investor cannot invest directly in an index.
The second issue deals with the timing of fundamental data. Fundamental data can lag market
moves both near market tops and during market bottoms. Fundamental data also experiences
heavy revisions, meaning today’s numbers will be revised in the future and sometimes will look
nothing like they do today. As investors gauge the fundamental health of the economy, they
can keep in mind these two issues. We think some of these issues can be mitigated based on
what data point one looks at to determine “fundamentals.”
Please see the back page for terms and definitions.
4
What Data Points to Gauge Market Health? Below are five “indicators” that are used to build
the Fundamental Index in the previous chart. For all but the Purchasing Managers Index, the key
is the trend – not the absolute level. (Most of the indicators are charted by the Federal Reserve
Bank of St. Louis.)
•
Purchasing Managers Index (PMI): The Institute for Supply Management has 300
purchasing managers fill out a questionnaire on a multitude of topics ranging from
employment, inventory, prices, etc. This data is scored for each line item, and then an
aggregate total is generated – this is the headline PMI number seen in the news. A reading
above 50 means the economy is expanding, and a reading below 50 means the economy is
contracting. Because of its focus on multiple data points around business activity and the
frequency of the data (monthly), it has been a reliable indicator. It is also considered to be
a leading indicator, but its popularity may hinder its ability to lead in the future.
•
Domestic auto sales: Auto sales are an important indicator because of all the different
industries involved, such as the service industry, manufacturing, raw materials and
technology. An automobile is a large purchase, and one that is often financed by the
buyer. Therefore, demand for new cars and the willingness to finance those purchases give
insight into the health of the consumer as well as the growth of industries that create and
support the auto industry. If the economy were expanding, we would expect the six-month
trend in car sales to be trending higher.
•
Capital goods: The official data point we use is Manufacturers’ New Orders: Nondefense
Capital Goods Excluding Aircraft. This number comes out monthly, is a leading indicator
calculated by the Conference Board and is a gauge for corporate capital expenditures in
the US economy. Why is this number significant? In an expanding economy companies
are investing in their businesses by building factories and updating machinery, software
and technology, among other things. If corporations feel the economy is going to slow
down, they may be hesitant to make these investments and may even cancel projects. If
the economy is growing, we expect capital goods orders to trend higher and grow as the
economy grows.
•
Earnings growth in the S&P 500 Index: Growth in corporate earnings may be an obvious
indicator; however, it tends to lag the broader stock market. It starts declining after
equities decline and doesn’t start rising until after equity prices start to rise. But even
though it lags, it is still a key metric in my view to judge corporate health. As the economy
grows, so should corporate earnings. For the purposes of monitoring the health of the
US economy, we use the companies of the S&P 500 Index. To determine the trend, we
compare the current earnings level with the level six months prior.
•
Credit spreads between high yield bonds and Treasuries: A credit spread is the difference
between a government bond of a certain maturity (for example, 10 years) and a high yield
corporate bond of similar maturity. As the interest rate difference narrows between high
yield debts (“risky”) versus US Treasuries (“safe”), it implies that lenders feel comfortable
about the risk they are taking by investing in a high yield corporate versus a Treasury.
However, if the spread starts to widen out, that means lenders want to be compensated for
their risk. Credit spreads and equity prices tend to be negatively correlated, and in my view
the trend in credit spreads is the most effective gauge on market fear. To view this trend,
we look at the BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread.
Please see the back page for terms and definitions.
5
Hedging When the Fundamental Indicators are Suggesting the Economy is Slowing Down
Hedging on fundamentals alone poses different challenges than relying on valuation or event risk.
The primary challenge is if the data is lagging, then there is a good chance the market has already
factored in the declining fundamentals. Another challenge is the direction of interest rates. If the
future direction of rates (think 1970s) is higher, then bonds pose risk, which is a challenge if
investors want to cut exposure to equities and increase exposure to government bonds.
Declining fundamentals often lead to recessions, and in those situations a more aggressive
rebalancing of the portfolio out of equities into cash or government bonds may be necessary. To
give an idea, below are three scenarios with potential hedges for each. Please note that these are
just examples, and any potential actions would need to be discussed with your financial advisor.
Scenarios
Fundamentals
Equity Variations
Trend in interest Rates
Potential Action
Base Case
Declining
High/fair
Flat to lower
Cut equity exposure and
add government Treasury
bond exposure
Higher Rates
Declining
High/fair
Higher
Equities High Yield Bonds
Flat to lower
Cut only risk-on equities.1
Increase fixed income
exposure.
Fundamentals
Lag Market
Declining
Low
For illustrative purposes only.
You will notice the examples above do not mention using options or VIX futures, primarily
because recessions tend to last months if not years. The short-term nature of options and VIX
futures don’t necessarily lend themselves to drawn-out declines. However, the next section of
this paper looks] at the interplay between three risk factors and considers the many dynamic
ways investors can hedge. For situations where only the fundamentals are declining, a broad
rotation out of equities into bonds might be something for investors to discuss with their
advisor. But in our view, most major market downturns are a combination of at least two
drivers, if not all three of them, which would call for a different approach.
Putting it All Together: Valuation, Event Risk and Fundamentals
Major market contractions do not happen in a vacuum. Oftentimes the media will look for that
one special driver and blame the selloff on that event. Unfortunately it isn’t that easy; usually a
combination of factors is in play. In 2007, fundamentals started to break down. In the spring of
2008, Bear Stearns was sold. Earnings declined, causing valuations to become lofty. And then
Lehman Brothers collapsed. It was a perfect storm — the “sum of all investment fears” if you
will. The story in 2000 and 2001 had a similar pattern.
In thinking about those situations and others like them, a picture forms — not of a sudden
shock, but of an unfolding drama or process. There is no crystal ball to tell investors what is
going to happen. The best investors can do is to have a process in place to hopefully minimize
the damage done by the financial storm. Hedging comes at a cost: You may be early and
miss further gains, or you may be late and lock in some losses. So how can investors hedge
effectively so that they respect and protect against the risk, but also give themselves room to
be wrong on timing? On the next page is a matrix that is meant to be a general guide when
one or two of the factors are in play. It isn’t bulletproof; it is meant to be a starting point for
investors to discuss with their advisors.
Please see the back page for terms and definitions.
6
The goal of the matrix is to be flexible as well as to address the risk.
•
Fundamental breakdowns, in our view, have a higher potential of causing a drawn-out
contraction, so the willingness to be aggressive in hedging is higher.
•
Event risk tends to have a lower probability than we expect, so the choice of hedging
vehicle relies on a tool that is flexible and potentially lower in cost.
•
High valuations can persist, but if they are accompanied by event risk or fundamental
weakness, then the level of aggressiveness in hedging should increase from rotating to
potentially exiting equity exposure.
Remember, the market is always evolving with new information every day. Before acting on
new information, it’s key to understand how it fits into your long-term plan and process, and to
discuss the potential effects of any changes with your advisor.
Sample Examination of Market Factors and Potential Portfolio Actions to Consider
Secondary Factors
Valuation
Core Factors
Valuation
Event Risk
Trend in Interest Rates
Potential Action
•
Rotate into defensive sectors.
•
Rotate into defensives/ smart beta.
•
•
Rotate into smart beta portfolios.
•
Rotate overvalued (high PE) equity
exposure to government bonds.
•
Rotate into undervalued
international equity.
Utilize tactical option hedges
for sectors directly impacted
by the event.
•
Utilize options to hedge remaining
equity holdings.
•
Rotate into defensives /
smart beta.
•
Utilize options on broad market
stock indexes.
•
Trim risk-on equity exposure and
rotate to government bonds.
•
Utilize tactical option hedges
for sectors directly impacted
by the event.
•
Utilize options on sector-or stylespecific exchange-traded funds.
•
•
Utilize options or futures on
VIX Index.
Utilize tactical hedge via options
for remaining equity exposure
(sector / style / country risk).
•
Rotate equity exposure to
government bonds.
•
Rotate equity exposure to
government bonds.
•
Rotate equity exposure to
government bonds.
•
Rotate equity exposure to
Treasury inflation- protected
securities / commodities.
•
Rotate equity exposure to
Treasury inflation-protected
securities/commodities.
•
Rotate equity exposure to
Treasury inflation-protected
securities / commodities.
•
Cut risk on equity holdings and
increase fixed income.
•
Cut risk on equity holdings and
increase fixed income.
•
Cut risk on equity holdings and
increase fixed income.
Fundamentals
For illustrative purposes only.
Please see the back page for terms and definitions.
7
Definitions
Correlation indicates the degree to which two
investments have historically moved in the same
direction and magnitude.
Credit spread is the spread or difference between
a higher yielding or lower quality security and a
benchmark security such as a US Treasury.
Duration is a measure of the sensitivity that a fixed
income investment has to changes in interest rates
measured in years. The larger the duration number,
the greater the sensitivity to interest rate changes.
A futures contract is a legal promise to buy or
sell a commodity, currency, etc. for a set price at a
set date in the future. The majority of the futures
contracts traded on the exchange floor are settled
or swapped for cash before the expiration date,
meaning the owners of the contracts never take
physical delivery.
An option represents the right but not obligation
to buy or sell an asset.
The option adjusted spread is a spread relative
to the Treasury spot rate curve that is adjusted
to account for credit risk and liquidity risk. When
valuing a bond with an embedded option, it is
necessary to adjust the spread for the value of the
embedded option.
Treasury inflation protections securities (TIPS)
are US Treasury securities issued at a fixed
interest rate but with principal adjusted every six
months based on changes in the consumer price
index (CPI). At maturity, TIPS are redeemable
either at their inflation-adjusted principal or face
value, whichever is greater.
Volatility is defined as the annualized standard
deviation of returns.
Index Definitions
The BofA Merrill Lynch High Yield Master
II Index monitors the performance of below
investment-grade US dollar-denominated corporate
bonds publicly issued in the US domestic market.
The CBOE Volatility Index® (VIX®) is a key
measure of market expectations of near-term
volatility conveyed by the S&P 500 stock index
option prices.
The Wilshire 5000 Total Market Index represents
the broadest index for the U.S. equity market,
measuring the performance of all U.S. equity
securities with readily available price data.
US Labor Diffusion Index measures how
widespread changes in employment are across
various industries. It depicts the breadth of
job creation.
The Purchasing Managers Index is an indicator
of economic health of the manufacturing
sector and is based on new orders, inventory
levels, production, supplier deliveries and the
employment environment.
P-HDGEQPR-WP-1-E
US7045
06/17
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indirect, wholly owned subsidiaries of Invesco Ltd.
Note: Not all products available through all firms
Before investing, investors should
carefully read the prospectus/
summary prospectus and carefully
consider the investment objectives,
risks, charges and expenses. For this
and more complete information about
the Funds call 800 983 0903 or visit
powershares.com for prospectus/
summary prospectus.