How hedging can help investors avoid a "slap in the face"

Portfolio manager explains strategy to earn good risk-adjusted returns in late-cycle conditions

How hedging can help investors avoid a "slap in the face"

The clock is ticking towards recession and investors must understand the risk they are building into their portfolios, according to a portfolio manager.

Michael White, of Picton Mahoney, believes that after 2017 - a year that made investing look easy - and with macro indicators suggesting a January peak, conditions are ripe for a “slap in the face” for complacency.

He said his company’s hedging strategies are designed to mitigate those risks before they jump up and bite you and that the cycle stage means the easiest opportunities for returns are probably over.

He said: “I don’t think enough people pay enough attention to the aspect of quality of return. It’s very difficult to talk to an investor about risk-adjusted returns because they just see the number, they see the rate of return and that’s all that matters. As long as that helps them reach their goals, then they tend not to think about risk.”

White added that, with the topping process under way, it’s time to think about how to garner that “last bit of return on offer” without subjecting clients to undue risk.

This is done, he said, by offering a broad gamut of strategies, including a pure hedging market neutral tactic. The goal is to mitigate, if not totally eliminate, beta by shorting one dollar for every dollar you are long.

White explains: “In a traditional fund, the decision to be bearish on a market is a question of raising cash but you’re long and committed, and your portfolio is subject to that broad market risk.

“Every stock has a beta which has sensitivity to that market risk, so what we’re trying to do in market neutral is observe the beta in a stock and we’ll short it, or hedge it, by shorting another stock that eliminates the beta of that long position.

“So the return you’re left with is what we call alpha – a return that’s attributable to management skill and stock selection where the beta, the market risk, is not at play in the returns straight.”

He added that this brings into focus what he believes is a misnomer about “alpha”; that it’s a manager’s ability to outperform the market. He said: “That’s not what it is. It’s a return based on good security selection and portfolio selection. You could have a manager who’s up 15% when the market is up by 10% and it’s not alpha, it’s a high beta portfolio.”

Citing the efficient frontier and how hedging strategies aim to push those boundaries, he said it’s important not to have blanket correlation in your portfolio in order to protect assets.

He said:  “It sounds ideal obviously - more return less risk – but it is more and more about mitigating the risk factors and ensuring what you’re adding to the portfolio doesn’t behave like everything else you already own, so that when there is volatility that affects your assets, you’ve got something in your portfolio that is behaving differently.”

He added: “We’ve got a lot of history on markets and prices and everything else, and we know what the historical rates of return are. We obviously can’t look forward but based on how all these assets behave through history in various environments of economic growth and inflation, we can build a portfolio that suits any given environment in the future. Whether it’s inflationary or disinflationary, high growth, low growth, there is an optimal mix of assets to own regardless of what the cycle looks like.”