Harin de Silva and James Gudger, discuss the challenging environment investors find themselves in and how hedging strategies can help investors protect capital and navigate these times.
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James Gudger: I’m James Gudger, product specialist for the Systematic Edge team at Allspring Global Investments, and you’re listening to On the Trading Desk®. Now if you’re someone like me who’s regularly engaging with investors or other industry professionals, you can certainly relate to the unusual environment we found ourselves in this year. Today we’re going to be discussing hedging strategies and how clients are finding ways to protect capital and navigate these challenging times. We have Harin de Silva, co-head of Systematic Research at Allspring Global Investments. Thanks for being here today.
Harin de Silva: Hi, James. Thanks for having me on.
James: What is it that you’re seeing in markets right now? And why is it that the playbook might be a little more challenging—perhaps fairly different from market pullbacks that we’ve seen in the past?
Harin: Very different playbook this year, James, because we’re starting from a point where interest rates are at all-time lows. If you think about history as we know it, the last 100 years of investing in the U.S. market, every time we’ve entered a recession, the Fed’s (Federal Reserve) been in the position to cut rates to stimulate the economy and boost bond portfolio returns. That is not happening in this cycle. And what that means is the traditional solution of having 60% in stocks and 40% in bonds isn’t going to be enough to protect your portfolio over the coming decades.
James: So, it sounds like you’re still somewhat cautious on the outlook for the bond market right now. What can you say about that and what alternative methods would you propose to navigate that?
Harin: I think you need to think about how you can build a portfolio that’s diversified. The whole point of diversified investing is that you think about all possible scenarios and you build a portfolio that’s hedged. And I think in the current environment, a good thing to do is to go back to the formation of head strategies in the late 1930s by Alfred Jones where he actually said, “The best way to hedge your portfolio is to have a short position of stocks in the portfolio.” And I would really advocate that as a way of navigating your way through this very difficult decade that we’re facing.
James: Going back to the 1940s, can you say a little bit more about what led to the formulation of these types of strategies?
Harin: One was the very big negative returns people experience and also the extreme level of volatility. Very different from the Great Moderation that we experienced in the 2000s. So big down markets, certainly high interest rates, but really the idea that sudden shocks could come at you in a way that you couldn’t actually predict. So, if you were somebody investing in the late 1930s, you would have seen a major world war. You were seeing another one develop. And you realized some of these events are really hard to predict. So, I need to build a portfolio that’s going to be resilient to big shocks. And I think A. W. Jones’ insight that having a portfolio that included short positions in equities to reduce volatility is really what led to the formation of hedge funds. And I think this is something that’s a little-used tool that really deserves an allocation in everybody’s portfolio—especially in the low-rate environment we’re facing right now.
James: Clearly, you’re a big believer in defense. Now, what sort of tools have you found most successful in adding that defense and managing these risks for your clients?
Harin: Well, having something in your portfolio that’s going to appreciate when the market goes down is really important. Historically, that’s been fixed income. Sometimes it’s been gold. Those two things aren’t working right now—fixed income for obvious reasons. So, I think having a short position in your portfolio is important, but also having a short position that is cost effective. If you short by buying puts, for example, that’s very expensive. That’s going to reduce the return of your portfolio, even though it reduces the volatility. Shorting something like high beta securities is something that’s very good to do because high beta securities underperformed the market. So, it’s not going to be the cost to your portfolio. It’s going to be a creative to return, but it’s going to reduce volatility dramatically. So, I think there are two things you need to be effective. One is it’s got to appreciate when the market goes down, but it also has to have a positive expected return. And I think shorting high beta securities ticks the box on both those dimensions. But it’s something I think everybody needs to think about as a way of protecting their portfolio.
James: Something that takes a fair amount of skill to implement. Can you tell us more about how you’re able to identify these short candidates?
Harin: So, there’s two ways to do it. One is to do it by picking individual stocks. It’s something that takes a lot of research, takes a lot of risk management to rebalance the position. But you can do this by, for example, shorting a high beta ETF (exchange-traded fund). So, there are several high beta ETFs that shorting an ETF is actually something that’s quite easy to do, and when including that in your portfolio, you’ll find it really helps offset some of the losses you see in your portfolio. For an individual or for an advisor who has a diversified portfolio and doesn’t want to spend a lot of time in portfolio construction, I tell them to look at an ETF solution. For somebody else, I would say look at high beta, betas of stocks that are easy to obtain, but also think about the other tilts in your portfolio. Not only do you want to short high beta, you also want to short securities that have poor fundamentals, have poor quality, have poor momentum. And if you use all these screens, you’ll find that you can build a short portfolio that’s going to underperform the market. So, it’ll be creative to return and reduce volatility at the same time.
James: Harin, do you have any parting thoughts for our listeners?
Harin: I do. I would urge people to think about the experience we’ve had in the last three years in that we’ve had three diverse events. We’ve had a pandemic. We’ve had inflation that we couldn’t even imagine would happen. If he told me three years ago that we see double-digit inflation, I wouldn’t have believed you. We are seeing economic and global uncertainty as a result of the issues in Ukraine. So, you’re seeing three different things arrive at your doorstep. And if you look at history, these types of events occur with way more frequency than they did in the first 20 years of the century. And you should be building a portfolio that can be resilient to this type of environment. And that’s what we try to do in all our portfolios.
James: Thank you, Harin. I hope that our listeners can put some of this valuable insight to use as they consider the many alternative playbooks that are at their disposal—particularly right now.
Harin: Thanks for having me, James.
James: Oh, our pleasure. That wraps up this episode of On the Trading Desk®. If you would like to read more market insights and investment perspectives from Allspring Global Investments, you can find them on the firm’s website, allspringglobal.com. To stay connected to On the Trading Desk® and listen to past and future episodes of the program, you can subscribe to the podcast on Apple Podcasts, Spotify, or wherever you get your podcasts. Until next time, I’m James Gudger. Thanks for listening.
Disclosure
Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses. Beta measures fund volatility, relative to general market movements. It is a standardized measure of systematic risks in comparison to a specified index. The benchmark beta is 1.00 by definition. Beta is based on historical performance and does not represent future results.
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