Hedging Is Valuable Insurance Policy in Down Markets

When optimism turns suddenly to pessimism, market corrections can be severe. A hedged approach to equity investment can often prove a valuable commitment in a balanced portfolio.

During the bull market of the past 11 years, hedge funds fell out of favor. Many investors felt that fees were too high, especially as performance lagged. These criticisms were particularly acute in an era of low-cost index funds.

However, an AMG analysis of indexes over the past 25 years for U.S. small and large cap stocks, as well as global equities, reveals multiple periods of double-digit declines. In the worst of times, such as when the tech bubble burst in 2001 and the global financial crisis of 2008, equities were off from 35% to 55%. But equity hedge-fund indices generally suffered less than half of the broader equity-index declines.

Entering 2020, equity markets seemed poised to continue the long bull-market run, but that all changed with the COVID-19 pandemic. Financial markets are tumultuous as investors are uncertain how severe the outbreak will eventually prove when it will be contained and what governments worldwide will ultimately do to mitigate the economic impact.

Historically, hedged equity portfolios have protected against roughly half of the losses when markets experience double-digit drawdowns. That also appears to have been the case in January and February. While risk-asset declines in March are proving substantial, select hedge-fund indexes providing mid-month updates indicate the hedge is still holding up.