What is hedging an investment?

Hedging is a technique used to try to limit or protect an investment against potential losses. It’s a complicated technique that has many pros and cons. So how does it work?

What is hedging?

Hedging is generally used by professional investors and fund managers. It’s not the sort of thing a casual investor would typically get involved with, but investments that use hedging techniques are fairly common, so it helps to know how hedging works.

A very simple explanation of hedging is to think of a game where you bet on the toss of a coin. The coin may come up heads or tails. Bet correctly and you double your money, bet incorrectly and you lose your money.

You bet $1 that the coin will come up heads. If you’re right, you get $2 – a $1 profit on your investment. If you’re wrong, you lose your $1 – a $1 loss. The level of risk here is high.

Let’s consider a different approach that’s more in line with hedging. You bet $1 that the coin will come up heads, and you also place a bet of 50c that the coin will come up tails. Hence the phrase, to hedge your bets.

If you’re right, you get $2 on the heads bet but lose 50c on the tails bet so you’ve got $1.50 – a 50c profit. If you’re wrong, you lose your $1 bet on heads bet but double your money on your tails bet so get $1 – no profit, but no loss either.

You can vary the amount you place on your second, hedged bet to get different outcomes, but the end result is the same – you limit your losses but also limit your gain.

You are, to take the hedge analogy literally, building a hedge around your investment to try to protect it from any uncertainty.

Another simplified way to think about hedging is as a form of insurance. Like hedging an investment, when you take out an insurance policy you are agreeing to forgo a certain amount of money in order to reduce the financial risk to you should an accident or other unforeseen event happen to you in future.

How to hedge investments

In practice, professional investors use a range of methods to hedge their investments, but the basic principle of trying to limit losses remains. This can mean limiting the gains too but it can be a useful strategy when there is a degree of uncertainty or volatility in investment markets.

Setting up the various methods used to employ a hedging strategy can bring additional costs, so these have to be factored in as well.

Hedging also comes with risks. In the coin toss example there is an equal and opposite investment. Either heads or tails wins. In practice, investors take a risk that one hedged investment will offset the other, but that doesn’t necessarily come with a guarantee.

How to find hedged investments

As a casual investor you may encounter hedged investments in a number of ways, such as when considering a managed fund or an exchange traded fund (ETF).

For example, hedging can be used when dealing with international ETF investments.

Vanguard Australia’s Head of Corporate Affairs, Robin Bowerman, said currencies, for example, are notoriously volatile and difficult to predict.

“Fund managers usually hedge against currency exposure by taking out a contract called a forward foreign currency contract,” he said.

“Simply put, these are contracts where two parties agree to exchange currencies at a fixed rate at a date in the future, regardless of what the actual foreign exchange rate does in the meantime.

“If exchange rates turn against you, it won’t affect your investment return. On the flip side, if they turn in your favour you also don’t get the benefit of the upside.”

Australian Shareholders’ Association (ASA) Chief Executive Officer, Rachel Waterhouse, gave Canstar an example of a company using a hedging method on currency when dealing with an international trade.

“So, if an Australian company is buying a large asset in US dollars, which must be paid for in six months’ time, they lock in the exchange rate with a futures contract, to make sure they know the final amount to be paid,” she said.

“They may pay more than the actual exchange rate when the payment is due, and the futures contract has a cost, called a premium, but they have removed the risk of it being more than what they have planned for or can afford.”

What is a hedged fund?

You may encounter a hedge fund as an investment option. This is a pooled investment, similar to a managed fund, and the federal government’s Moneysmart website says the aim is to use a range of strategies to try to make a return in both rising and falling markets.

But it warns they can be more complex and risky than other managed funds, so it’s important to do your research to fully understand how a particular investment works. That includes the investment strategy and goals, and any fees involved.

Melbourne-born Alfred W Jones is credited with creating the first hedge fund, in New York in 1949, but the Australian Investors Association says the phrase is now “mostly historical”.

“Nowadays, hedge funds use dozens of different strategies, and it isn’t accurate to say that hedge funds ‘hedge risk’, when, in reality, many carry more risk than a simple index fund,” it adds.

The ASA advises caution when it comes to casual investors getting involved with any type hedged investments, which it says should not be seen as a “no risk” option. Again, careful research is needed and you need to develop your own investment plan that you review on a regular basis.

Remember too that past performance of any investment – hedged or not – is no guarantee of future performance.

When considering any hedged investment option, you should read any product disclosure statement (PDS) and other relevant documents, and seek some independent professional advice.

How can I hedge my own investments?

Hedging is usually a strategy employed by professional investors, but there are ways you may be able to simulate hedging with your own investment portfolio.

The ASA’s Ms Waterhouse told Canstar that diversification of your holdings can introduce a “natural hedge” which may help offset any downturns in value of some of your holdings.

“Think of the impact of changes to interest rates on shares and bonds, or shares that are likely to rise with the oil price while other companies’ share prices will fall as fuel costs rise,” she said.

Again, if you’re looking to diversify your portfolio it might be wise to seek some independent professional financial advice before making an investment decision.