While equities and practically all financial assets were battered between February 19 and March 23, 2020, those who were long volatility, and put options in particular, either hedged well against losses or even made money.
Those with convex exposure to downside protection reaped remarkable returns in some cases.
This ignited debate over the use of hedging strategies and the use of options in a portfolio for not only protection and tail risk hedging, but as potential returns sources in themselves.
Universa Investments, a small investment manager, gained significant attention for their returns during sharp market drop that accompanied the Covid-19 pandemic.
Hedging in the context of risk management decisions
Many investment managers believe that hedging is too expensive. While it may produce huge returns in short periods, it’s met with “slow bleed” type of performance in most other times.
It’s a generalization, but we’ve also argued in other articles that the evidence suggests that hedging, on average, is expensive and a drag on long-term performance.
Even when big volatility events hit that knock the value of many types of portfolios, the losses often prove transitory even if they are very painful in the moment.
Options sellers want to be compensated for underwriting financial insurance.
On net, option buyers pay a premium above fair value for an option in the same way private insurance businesses charge more than what’s needed to mathematically offset expected risk. That way they have a viable, profitable business over the long-run.
As a result, option buyers will have to know that they’re paying too much for protection – or by buying options as capped-risk bullish or bearish wagers on their own – over the long term.
This occurs for the same reason we collectively overpay for various forms of insurance. It helps limit the financial damage of a devastating liability should one occur. Paying regular insurance premiums becomes a normal part of life to get rid of various forms of left-tail risk.
Similarly, financial insurance is useful to have in order to limit losses when you need a certain level of protection in your portfolio.
You always want to make the risk of what’s unacceptable nil.
Mark Spitznagel, the founder, owner, and chief investment officer of Universa Investments, argues against the idea that hedging is excessively expensive. Naturally, he makes a convexity argument in his support of his fund’s options-based strategy of being long deep OTM put options.
“When the market crashes, I want to make a whole lot, and when the market doesn’t crash, I want to lose a teeny, teeny amount. I want that asymmetry… that convexity.”
Some nonetheless believe the longer term drag on performance isn’t worth the sacrifice.
We’ll consider Universa’s perspective first.
Universa’s tail risk hedging strategy
Universa is unique in the investment world because its actual capital risk is quite small.
While it had $4.3 billion under management at the time the Covid-19 pandemic hit (and received many requests afterward given its great performance in a time when most investment managers lost a lot), its actual capital risk is only around 2-3 percent of that figure.
Its return of 4,144 percent in the first portion of 2020 was achieved on not even $100 million worth of options.
On that $100 million of long put option exposure (heavily in equities), it produced a gain of over $3 billion for Universa’s institutional clients.
Universa performed well in its founding year of 2008 as well, returning 115 percent for the year.
Spitznagel still makes a fair point that big losses – namely, avoiding them – are essentially what matter most.
Having convex trade structures in place is a big part of risk management. Ideally you want to identify asymmetric risk/reward opportunities where you’re able to keep the big upside while not having unacceptable downside.
The bigger the hole you dig yourself, the more difficult it is to get back out.
If you lose 10 percent of your portfolio, you only need a comparable gain (about 11 percent) to get back out.
But if you lose 50 percent, you need a 100 percent gain just to get back to where you were. The ratio gets worse the larger the loss and it goes in a non-linear way.
The choice of hedging or not hedging doesn’t have to be a binary choice. The optimal decisions are dependent on context.
Some portfolios with concentrated risks or risk thresholds could benefit from prudent hedging. Portfolios that are entirely in equities have concentrated asset class exposure.
For others it’s not as necessary and could even reduce performance. Risk parity portfolios that aim to diversify across asset classes, countries, and currencies have better balanced risks and hedging against them isn’t as imperative.
There is no such thing as a standardized approach to hedging, or one that is scalable (in terms of what institutions look for in a strategy to commercialize it).
Both sides of the hedging debate are correct in some form. It depends on what your goals and objectives are and what kind of risk exposures are present in the portfolio.
Perpetual hedging is a drag on returns over the long term. The volatility risk premium does exist. At the same time, the other side is correct that tail risk and avoiding it to the best extent possible – or even profiting from it – deserves attention.
But they’re also not the only two approaches.
Matters of valuation
One way to assess the idea of whether hedging leans toward “likely prudent” or “likely wasteful” is to assess whether financial insurance is cheap or not.
In other words, what is the implied volatility from whatever options market you’re considering and does that make sense relative to its risk characteristics (e.g., realized volatility)?
Part of what made Universa’s gains so extraordinary was that when the Covid-19 finally derailed markets by a “once in a century” public health event stocks were expensive relative to earnings and financial market insurance in the form of options and other derivatives was comparatively cheap.
Not just cheap historically, but from the tail risk events that were present. For example:
- a brewing public health issue that was way underestimated in hindsight
- perceived political risk in terms of the possibility of a less business-friendly candidate becoming President of the United States (e.g., Bernie Sanders, Elizabeth Warren)
- high asset prices relative to their underlying earnings and trend of likely future earnings
That could make a positive case for a portfolio of deep, OTM put options for those who could benefit from such exposure.
Put options are contracts that give market participants the right to sell securities at a specific strike price by a certain date. They allow traders to pay out a relatively small amount to hedge a larger portfolio or make a directional bet.
This limited risk structure creates convexity with limited downside and potentially high upside. The allure of this creates the volatility risk premium.
The struggle of value-based wagers
Since April 2010, now well more than a decade ago, value has struggled against other forms of equity-based strategies.
In theory, value investing makes sense. If you buy companies with high cash yields relative to their prices, you should be able to come out ahead over time.
The same is true with respect to other forms of investing, such as real estate, where the goal is to buy properties below market value to achieve a higher cash flow yield and/or future price appreciation.
When interest rates decline, so do the yields of other assets
As a result, there have been few opportunities offering close to the traditional margin of safety that value investors like to have to sustain long-term gains.
All of the traditional metrics suggest a poor environment for value no matter what the metric:
– Shiller’s CAPE
– Tobin’s Q
– Market cap to GDP
Most value investors would consistently argue that the market is detached from its fundamentals and has been for a while.
But fundamentals to a value investor usually means seeking out a certain level of returns. Because of low interest rates pulling down the yields of everything else, it means that value investing in that sense isn’t going to work as well.
The Covid-19 pandemic hit markets slightly starting in mid-January 2020. But it was more of a SARS-like drop of some 5-10 percent in most major markets (US, Europe, Japan, China).
Most traders had lived through SARS and used it as a type of guide or heuristic of what might happen.
Equity markets recovered until they hit new highs on February 19.
The volatility of the S&P 500, historically and implied (as seen through the VIX) had been calm for a prolonged period.
CBOE VIX Index
(Source: Chicago Board Options Exchange)
Long periods of below-normal volatility also tend to sow the seeds of their own undoing. When volatility is low, yield becomes the more important factor to market participants.
This encourages leveraging up at the same time yields are declining as stocks go up. This buildup of financial leverage exacerbates shocks in the other direction when they do occur.
For example, if the forward yields on stocks goes from 5 percent to 4 percent, most investors still need the same returns as they did before. So, the inclination is to take on more leverage to magnify the smaller returns on equity into what they want or need.
Markets also have a tendency to extrapolate conditions forward even when it may not be appropriate to do so.
For example, since 1981 in the US, 10-year bond yields have gone from 15 percent to nearly zero.
That’s been a huge tailwind behind financial assets of all sorts due to how the discounting process works on the present values of financial assets, from bonds to stocks to real estate.
10-Year US Treasury decline from 1981 forward
(Source: Board of Governors of the Federal Reserve System (US))
With that interest rate tailwind largely out of gas, investors still bet heavily on stocks even when central banks can’t lower rates to help offset the drops in cash flows in a recession.
That creates more risk for equities. It also creates more demand for certain types of equities that have stable earnings – e.g., consumer staples, utilities – and those that are more instrumental in developing the leading technologies.
Some types of stocks can be considered stores of wealth if their earnings are relatively stable and predictable and their prices are not overly dependent on central bank or government action. Namely, they don’t necessarily need a big interest rate cut to offset a drop in earnings.
At the same time, you have influence from China coming up to challenge the West that’s causing countries to become more independent due to this conflict.
Instead of locating production where it’s cheapest, countries are having to think about creating independent supply chains even if it means lower margins. That contracts earnings and cash flow, holding all else equal.
The basic idea is that there is more tail risk than normal to go alongside high valuation concerns – i.e., lower forward returns at higher than normal risk.
Universa benefited greatly from the tail risk of a pandemic that no one considered much because it’s something that comes about so rarely.
And the worst-case scenario of a pandemic shutting off the revenues of some types of companies completely, especially cyclical companies or those dependent on public gatherings, was an event not built into most market participants’ distributions.
Universa nonetheless has a fairly static approach to tail risk hedging. It doesn’t place much, if any, emphasis on valuation in its models.
And once a tail risk event occurs, risk tends to be overvalued from that point forward.
Naturally, risk hedging tends to become the most expensive right around the time the market is at its bottom.
When risk is expensive, the price of protection against further damage becomes nearly prohibitive. At the same time, when the economy is having issues, policymakers have big incentives to get it going again.
Trading is difficult to do well because it forces people to do the opposite of their instincts.
When assets are high and volatility is low, there’s the bias to keep doing the things that work. In that case, owning stocks and shunning downside protection is common.
Likewise, when asset prices have just declined rapidly and volatility is high, then avoiding that pain becomes common by either selling assets or buying volatility.
But that’s the opposite of how it should work.
Preparedness for volatility and downswings in assets is wise. Therefore, holding hedges when assets are at record valuations and volatility is cheap may be prudent.
But it’s also dependent on the context of a portfolio.
Those who don’t own many stocks may not need tail risk hedging on equities unless they view such a tactic as a way to potentially add returns.
And once a huge drop has set in – e.g., 1932, 1974, 2009, 2020 – further downside risk is low due to the incentives to get everything going again.
Those in charge will do practically anything to save the system assuming they have the ability to (unique situations like Iceland in 2008 occur due to fears of losing their currency).
Financial assets are important because it provides a market for the money and credit that are used to help produce goods and services in the real economy.
Even during the 1918-19 pandemic, US markets fell by just 11 percent.
While there were many deaths in the US and globally during the Spanish flu (the number is unknown but likely somewhere in the tens of millions), they were not as damaging to businesses and incomes as the Covid-19 pandemic was due to a) the associated business shutdowns, and b) high valuations weren’t as big of a factor in 1918 as they were in 2020.
As an example metric, the 1918 market began with a CAPE of approximately 8x after the world was dealing with lots of political, social, economic, and general “world order” risk because of the First World War.
The 2020 market, by contrast, had a CAPE of over 30x.
Hedging in such a cheap market like 1918 would likely be an unnecessary drag on performance.
Even though a war economy is very risky since the ultimate result of the war has big implications on who has control of what and who the dominant superpower(s) are, this was heavily reflected in asset prices.
When earnings ratios are single digits, this prices in double-digit forward earnings yields. (The inverse of the P/E is the implied yield.)
Similarly, 2008 may have been an extremely volatile environment in the latter third of the year. But assets were cheap and buying volatility was very expensive.
Many shrewd investors were selling puts in 2008, not buying them.
This can only be achieved when there is cash to put to work. Hedges help to achieve this purpose. When equity values decline, hedges help provide cash through their appreciation to offset losses or even add value to a portfolio on net.
Those who hold strictly to value strategies, however, are not likely to hold onto equities when their forward rates of return are expected to be low.
Instead, they might move up the quality ladder to things like corporate bonds or government bonds.
Eliminating risk in cost-effective ways
Universa works by putting up just 2 to 3 percent of its capital at risk on its tail risk hedging methods.
The funding for this, in effect, can be achieved by putting the remainder into safer investments (mostly cash and safe bonds) and using the interest and coupons that those throw off to fund the tail risk protection puts.
This means in a normal environment, where there are no big downswings in equity markets, the fund effectively remains neutral.
The puts expire out-of-the-money and the interest and coupons essentially pay for the loss.
In market routs, the safe investments still pay off while the put options can pay off very well.
This is also called a “barbell portfolio” because of the opposite nature of the two investment themes. It’s a strategy that loses little to nothing the vast majority of the time, followed by big gains infrequently to very infrequently.
For single-company wagers
Some traders will also do this with respect to certain companies to either hedge or make bullish or bearish options wagers in a limited risk way.
For example, if one is long a risky stock, one might want to limit one’s exposure to that. Limiting the position size is one way. But there are different ways to go about it.
If the stock has a public bond market, the trader could go long the underlying bonds and use the coupon payments from those to fund put option on the stock.
For example, let’s say the company has a bond yielding 3 percent per year. The trader could use that 3 percent to spend on put option to minimize any loss in the stock beyond a point. He would then be free to capture all the upside without worrying about unacceptable downside.
Likewise, this strategy can be used to fund outright bearish wagers. The cash flow from the bonds can fund put options to bet against a stock in a limited risk fashion.
If the bonds yield a certain amount per year, one could use the proceeds to fund put options one year out, if the idea was to match the two.
For example, if the bonds provide $1,000 in coupon payments, that could fund $1,000 worth of put options.
Of course, in this case, you have to think about the fact that your funding source (the bonds) are not entirely safe. But they’re much safer than the equity, as shareholders are paid last in a theoretical bankruptcy scenario.
Especially on the bearish wagers, if the bonds are having problem, you know that your bearish bet on the stock is probably panning out even more so.
When companies default on their debt, it often (but not always) zeroes out shareholders, which is the optimal outcome for a plain put option position.
The topic of hedging produces debate in trading circles. Hedging is costly, but can produce benefits in excess of the costs if done prudently.
2008 forced many traders to reconsider how they structure their portfolios, and 2020 has done so in many ways as well.
Like many things, there is no black and white, “0” or “1” answer. There’s a lot of gray and is dependent on context.
Generally, it is advisable to consider hedging when there are concentrated risk exposures in a portfolio or when it’s unacceptable to lose beyond a certain amount.
For a portfolio that is long a lot of stocks, if a 20 percent drop in the equity value of the portfolio would be too costly, then one could consider hedging that out.
One can also improve return relative to risk in other ways, such as avoiding concentrated exposures and balancing among different asset classes, including stocks, bonds, cash, and even some amount of commodities and/or gold.
For any type of risk exposure, there can be a benefit to limiting it or getting rid of it altogether.
Risk can also be mitigated in ways that minimize the cost, such as using the coupons from safe bonds to fund put options to protect against the riskier parts of a portfolio.