Market Keeping You up at Night? Look for the Right Hedge

Like so many others in the industry, I was wrong.

For years, I was certain that the bull market was nearing its end. I thought the market was over-extended, and that, surely, the wild equities run was coming to an end. But everyone else was bullish, and perhaps rightfully so. And while I’ve watched equities continue on their spectacular rise, I do think now is the time (really!) to put a hedge in place. Here’s why. Here’s how.

Why hedge now?

The bull market has been great. I get it. It’s been the perfect antidote to the Great Recession, and there’s not an investor out there who wouldn’t love to see it go on forever. But the fact is that no one knows when it’s going to turn. And mark my words: it will turn! What will cause that shift is anyone’s guess, but my sense is that it won’t take much to scare people and push them to start selling. The market has been buoyed up ever since the November election. Expectations of what the new administration could accomplish included policy changes that would affect corporate expenses and revenues, as well as taxation changes that would have a positive impact on earnings. Now, four months in, it’s clear that many of those changes won’t be as easy as hoped. And while all of that remains conjecture, there’s no doubt that interest rates are on a slow and steady path up—a shift that has a very real impact on your client portfolios and how they need to be managed moving forward.

Investing 101 makes one thing quite clear: you make more by losing less. That’s why institutions are consistently heavy in diversification—in every type of market environment, including even the most bullish of bull markets. The reason: recovering from losses after a drawdown is extremely difficult. Any investor who lived through 2008 knows this all too well. And yet hedging has been a tough proposition in today’s market when the average value of the hedge—about 3-6%—has been completely washed out by an equal 3-6% of volatility. The good news is that, with interest rates rising, the scales are tipping. And with a typical hedge, volatility typically remains steady, while the rate of return is likely to nearly double. Suddenly hedging your portfolio is starting to look much more attractive after all.

So yes, if suitable, we believe it’s time to hedge. But how? What’s the best approach in today’s market, especially when it is possible that equities may continue to climb? How can you position your portfolios to seek continued growth while also seeking to protect them from any potential future downturn? Not all hedges are the same. That’s why the best place is start is to ask yourself one question: “What portion of your portfolio is keeping me up at night?

Rising interest rates

For many advisors, the answer is rising interest rates. Rising rates mean that fixed income is no longer on an upward trend. As a result, you need may need to find some vehicle to replace it that seeks to deliver the same type of volatility dampening, while also potentially providing competitive returns. Depending on your client’s investment goals, one way to achieve this is to use an ETF that has a volatility profile similar to aggregate bonds, and that attempts to replicate the risk-adjusted returns of hedge funds using various hedge fund investment styles.

An equities drawdown

If your biggest concern is the inevitable drawdown in equities, we believe the answer is certainly not to exit the equities market altogether, but rather to hedge using a strategy such as M&A (merger arbitrage). M&A has been used to hedge volatile equity markets for decades, largely because M&A returns are typically uncorrelated with equities. The approach seeks to deliver only one-third of the volatility while still capturing the upside of equities returns. That lack of correlation may be just the ticket when equities reach the end of their run.

Other alternatives

Other options include leveraging other alternatives to increase portfolio diversification. In the past three to six months, commodities have finally begun to look favorable again, and many analysts expect them to continue moving forward. And while, unlike in the equities space, there’s lots of room to run, diversification is key. After all, it’s never wise to put all your eggs in one basket. If suitable, one may consider investing in a well diversified, equity linked commodities ETF.

While often overlooked in a rising-rate environment, REITS may also help capture yield. As you might expect, that’s typically not the case for large cap REITS which, because they are highly correlated with the market, offer little as a diversification tool. Small cap REITS, however, are a different story. These “hidden gems” offer a yield that can be 50-75% higher. Plus, because fund flows are much less robust than they are for large cap REITS, small caps offer similar levels of low volatility—but with much greater opportunity for capital appreciation.

It’s time for a good night’s sleep

Now that the optimism about the new presidential administration has waned, many investors are much more willing to accept the fact that it may finally be time to begin to hedge their portfolios and put a plan in place to protect against a drawdown. It’s true that I may be wrong once again, but it will certainly be easier to have that conversation with your clients now—before the shift takes place—than it will be after the fact. Choose a hedging strategy that tackles your biggest concerns, and your clients will thank you in end. Even better: you’re bound to get a much better night’s sleep knowing you’ve set the stage for a smoother, safer path forward.

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IndexIQ ® is the indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC. Adam Patti is a registered representative of NYLIFE Distributors LLC.