Investors whose majority equity holdings are in the major banks have been rewarded with healthy dividends for years, but high dividend payout ratios are easily undone in a downturn. NAB’s 63% dividend cut, a whopping $3.5 billion capital raising, and close to a 50% decline in its share price in less than three months will leave shareholders licking wounds.
Commonly, investors concerned about short term equity losses, decide on a loss level they can tolerate, and put in stop-loss sell orders on their shares. One well-known market commentator has stated he will sell all of his portfolio if the market declines by 10%.
Other technical investors may look at 100-day moving averages and set sell triggers around that average.
There are two ways to hedge your equities without selling:
- Use derivatives such as options – a derivative is an investment that trades on the basis of an underlying security but does not invest in direct securities such as shares or bonds.
- Diversify and buy other assets
I’ll explore the use of options and follow up next week with some alternative assets. This note will be a little more technical than usual but also looks at some managed fund options, so please persist with the brief explanations first!
First, a word of warning, derivatives are complex and even the world’s best traders can get it wrong big time. You take a bet on the direction of the market, so you can think of an option as insurance, but just like insurance, the cost might outweigh the benefits.
What is a hedge?
A hedge is an investment that is made to reduce losses on an individual investment or to offset losses in a portfolio.
Most investments are subject to a range of risks such as general economic risks, inflation, interest rate, default, commodity, counterparty and currency. These individual risks can be hedged, or investors can choose to hedge market risk by investing in an index, such as the S&P500, ASX200 or the Volatility Index, known as the VIX.
Questions to ask yourself before you hedge
Hedges can be expensive and rarely precisely offset losses. So, before you decide to hedge an investment you need to understand your tolerance for risk – what level is acceptable?
A hedge may mean you don’t take advantage of an upturn in markets, so you will need to ask yourself how much upside are you willing to sacrifice? If the market has already declined, such as in the current market, could the possible gains outweigh further losses?
Related reading: What is a hedge fund and how does it work?
Options and futures
Using an option to hedge your equities aims to reduce the impact of a declining market. This can be done in a number of ways – using just one option, or a combination.
An option is an agreement that gives the buyer the right, but not the obligation to buy or sell an asset at a specific price. Sometimes an option can be executed at any time before the expiry date, and in others, it can only be executed on the expiry date.
A call option gives the holder the right to buy the underlying instrument at the strike price.
A put option gives the holder the right to sell the underlying asset at the strike price and is therefore most commonly used for hedging purposes. For put options, the option is said to be in the money if the current spot price is below the strike price. The option is out of the money if the strike price is below the spot price.
A collar uses both a put and a call option.
The counterparty agrees to the other side of the option for a price – this is known as the premium.
Options are complex and many investors lose money, if you want to start trading, please consult your financial advisor and consider a course or courses. The ASX has an online options course, that may be of interest.
A future works differently. You agree to buy a security at a set price at a future point in time. The ASX has a great example, ‘assume you hold a share portfolio that trades in line with the S&P/ASX50 index. By selling index futures, you can lock in the value of the portfolio until maturity of the futures contract’. In essence, if the index falls, your futures contract makes money, offsetting actual losses in your equity portfolio. A full explanation can be found on the ASX website.
An option gives the buyer the right but not the obligation to buy or sell securities in the future, while a future is an obligation to buy the securities.
DIY or find a hedge fund that will help you meet your goals
If you would like to do-it-yourself, the major banks and ASX trade are options.
CBA makes options available on an over-the-counter basis, meaning they are not traded through an exchange. They trade in 40 shares for a minimum three days out to five years, unless otherwise agreed. The minimum transaction is $50,000. Margin lending is also available.
There are hedge funds that are more complex and higher risk than standard managed funds. They employ a wide range of strategies to protect portfolios and take advantage of various economic conditions. ASIC’s Moneysmart website has a good summary of hedge funds and some of the tactics they employ, such as using derivatives and short selling.
Here are some funds that have performed well over the last few months.
These two ASX listed BetaShares funds hedge the ASX200 Accumulation Index and outperform when the S&P ASX200 Accumulation index underperforms. The funds sell equity index futures contracts, based on the ASX SPI 200 Index.
BEAR aims to be short the index between 90 and 110% on any given day depending on market movements, while BBOZ exposure is magnified at 200 to 275% on any given day.
Recent performance shows the funds have performed to expectations. In the month until 31 March 2020 BEAR had shown a positive 16.85% and BBOZ 33.03%, slightly less than double BEAR, with the S&P ASX Accumulation Index -20.65%.
Both funds had been trading at significant negative returns until the latest downturn, as evidenced by the returns since inception of -6.33% and -9.79% respectively.
The difficulty for investors is buying into the fund at the low point when potentially the biggest negative returns are shown and selling when returns are high.
The ease and performance of the strategy make both funds attractive hedges.
This fund aims to have the best of both worlds – exposure to the ASX20 offering returns of 6% ‐ 8% p.a. in trending markets, greater than 8% p.a. in volatile markets and BBSW 3% in stable markets. Income is paid from dividends and franking credits and is a minimum of the cash rate plus 3% p.a., and was 4% p.a. as at 31 March 2020.
The fund has hard protection in place to minimize the downturn in any one quarter, to 3% of capital.
The maximum NAV capital draw‐down has been limited to – 2.2% since inception in December 2010.
It has operated within its guidelines now for 37 consecutive quarters with a return since inception of 5.26% p.a. and over the last year of 16.94% to 31 March 2020.
Elizabeth has worked in financial markets for more than 20 years holding positions in communication, credit analysis, and education for retail and institutional banks and other financial institutions. For more than six years she has had a regular column in The Australian.
Original article published for The Eureka Report.