Home >Money >Calculators >Portfolio hedging is smart but it has risks and costs

The equity markets are at all time high levels. Some reports suggest that the current higher levels are largely liquidity driven. This might mean that negative news can lead to sharp corrections given the high valuations. To protect against this situation in uncertain times, why not hedge your portfolio?

Portfolio hedging is a concept which attempts to protect returns in a market correction and assumes importance when peak valuations are uncertain, not fully supported by fundamentals. There are different ways to approach hedging. Other than diversification and tactical asset shifts, derivatives like options can also be used. Each strategy has its own benefits and limitations; ultimately the aim is to lose less in bad times. Moreover, portfolio hedging comes at a cost for long term investors. Should you indulge in this idea or is it enough to tide over the uncertainty by staying the course?

Hedging through asset allocation

Diversifying your portfolio with more than one asset type can create a natural hedge in your portfolio. For example, invest 60% in equity and the rest 40% in other less volatile assets. In a market correction, only the former gets impacted, and the latter delivers return and to that extent your overall portfolio returns are partially protected. You can also tactically manage the allocation by booking profit in equity when the market is perceived to be overvalued.

This amount can remain in cash for a limited period. According to Nishant Agarwal, head-family office advisory, ASK Wealth Management Co. Ltd, “You can have a simple cash hedge in the portfolio, sell out of equity and wait to re-enter when your market view is positive. There is no cost, but long-term return objective can get affected negatively."

The drawback is that it is difficult to precisely time the change in asset allocation. The market could start correcting sooner than you expected or it could recover faster leaving you unprepared to re-enter equities at a low price. While cash is a hedge, there is an opportunity cost and a high risk that you can get your timing wrong. A diversified asset allocation is the best way for long term retail investors to protect portfolio returns over longer periods.

Hedging through structures

Another way is to allocate a portion of your portfolio to structures designed to help protect value in the event of a correction. Structures are created using derivatives and debt. The derivatives help in protecting downside if the markets fall; there could be limited upside as well in case of a rally. The debt portion is used to generate steady return. The investor gets return in the form of a promised yield on a debenture as the structure is packaged like bond. These help in managing volatility, but there are caveats here.

Firstly, you must understand the type of structure you are buying into. According to Feroze Aziz, deputy chief executive officer, Anand Rathi Private Wealth Management, “We recommend using structures for up to 30% allocation in a portfolio. There are several variables involved in a derivative-based structure and ideally one should go by what the options trader recommends in a particular market environment rather than trying to customize for each investor."

One should not indulge in structures which are for a very short timeframe, are binary—designed to return an upside or give nothing at all and options whose outcome can change based on interim market movement or only for saving tax, he added.

The structure comes at an inbuilt cost of anywhere between around 1-2% per annum. However, most are illiquid that don’t allow for an early exit.

Risk is highlighted in sharp market movement. Agarwal says, “Such strategies often don’t work when markets are at extremes."

Solvency of the issuer is also important. A structure is packaged as a bond; it is rated by a credit rating agency. Along with rating, evaluate the derivative risk. In case of the worst-case scenario, derivative margins call could become too high putting pressure on the issuer’s solvency and ability to pay forward.

Make sure the structure is not locked in and gives you the option to exit midway. The solvency of the issuer is an additional risk for securing a payoff with relatively better certainty during volatile equity markets. Despite rating, care needs to be taken to evaluate issuer solvency.

Hedging with options

You can hedge directly with options for protecting your equity portfolio. This commonly involves buying a put option for say a three-month time period (expiry); buying a put option gives you the choice to sell the index (let’s say the Nifty 50) at a predetermined level (used if you think the market is going to fall). To buy an option, you must pay a premium.

The underlying value covered should be roughly equal to your equity portfolio value and if the market corrects, you can exercise the option; the index level for selling is fixed which means losses on the equity portfolio can get set off against option gains. It may not be a complete hedge, especially if the portfolio construct is tilted towards mid-cap stocks, because the option will give returns in line with index movement whereas your portfolio change can be different for the same period.

The cost of a one month put option today is around 1% of index value (option exercised at 9,200); to cover a portfolio of say 25,00,000, it will cost you roughly 24,000 per month. But this is dynamic and changes as you get nearer to maturity.

Solutions could involve longer dated options going into 2-3 years. To lower cost, sometimes a more layered solution is advised like a put spread (selling and buying a put simultaneously); you receive a premium for selling which lowers your cost. The devil is in the details.

Selling a put option by itself is a very risky proposition; combined with buying a put will cover the risk but you must be careful about setting the exercise level of this put option. Aziz says, “Rather than buying a put spread, a long dated—3 year, at the money put can be bought which is likely to cost around 6% (of the portfolio value); that is a cost of 2% per year to protect your portfolio." Not all advice long-dated put optionss because there is no liquidity for these securities.

Aziz says that using liquid options is not always practical. Anand Rathi is a market maker, which means they can be the counter party for illiquid long dated option you need and if you are buying a Put you pay them premium, if you sell a Put they pay you a premium. One must be cautious about lack of effective price discovery as there is no natural market.

Moreover, in the absence of a market maker your strategy may not work. Prateek Pant, co-founder and head products and solutions, Sanctum Wealth Management says, “It is difficult for individuals themselves to structure options based solutions or execute portfolio protection through derivatives for large amounts. The market is illiquid and that leads to transparency gaps in option pricing."

The Indian market is not yet used to the concept of portfolio protection and the simplest form is to buy a three month put option, he added. As an investor check what you are gaining from any proposed option strategy. Is the objective of portfolio protection being met, is any new risk getting added and is the cost of taking this hedge too high?

Lastly evaluate the trader who is helping you achieve this. In volatile markets the margin required against options that you have sold (put sell or call sell) can suddenly rise sharply and inability to furnish that can draw huge loses. According to Anshu Kapoor, head - private wealth management, Edelweiss Financial Services Ltd, “Hedging should be done only if you are 100% invested in equity. It should be simple and consistent. The more complicated it is to understand, the fewer people will engage in it as risks like margin calls start to weigh in."

Hedging is done to protect the portfolio from downside, but this is best left to the ultra-high net worth individual who can decipher the costs and more importantly the ability to absorb the risk of capital loss where derivatives are used directly. Exercise caution and judgment when a single financial services provider creates a solution and is involved in the built in transaction as well; the lack of transparency might mean that the cost is higher than it appears.

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