Strategies: When is hedging appropriate for clients

But when you get down to it, the real challenge for you is managing client expectations – or, to put it another way: understanding the emotional roller-coaster that has come to be characterized in academic circles as “behavioural finance.”

The trick is to keep your clients invested because a well-thought-out portfolio will get clients where they want to go over the long haul.

To that point, I recently reviewed the performance of the Financial Post indices that I co-developed along with Eric Kirzner, who is the John H. Watson chair in value investing and a professor of finance at the University of Toronto’s Rotman School of Management. These portfolio indices represent a typical asset mix and geographical breakdown of mandates held in three classes of Canadian portfolios: conservative, balanced and growth.

These indices have a 17-year history. What’s interesting is that all three indices have generated about the same return. In other words, they all got a client to the same place but took different paths to get there. All of the focus around suitability comes down to a client’s ability to stay invested, which ultimately is determined by that client’s ability to tolerate risk.

Using tools to hedge out some equities risk makes sense if your client is unduly concerned. But using a hedge should be a last resort only after having a discussion with the client around the longer-term implications of his or her current portfolio.

Think about it this way: if your client really is worried, the first consideration should be to assess the merits of transferring the client’s portfolio to a lower-risk mandate, such as moving from a growth portfolio to a balanced model. A secondary consideration is to raise cash strategically after a discussion concerning opportunity costs associated with such a strategy. Only then should you consider hedging as an alternative.

Viewed in that context, hedging becomes another tool to manage clients’ emotions. If taking action to hedge away short-term equities risk helps a client stay focused on the long term, then hedging makes sense.

The advantage of a hedge – assuming it is appropriate for your client’s circumstances – is that complacency among market participants has made hedging relatively cheap to execute. The cost of buying index put options is at the lower end of the implied volatility spectrum – and has been that way for some time.

Put options on broadly based North American indices are trading between 12% and 14% implied volatility. Thus, buying insurance via one-year at-the-money puts on the S&P 500 depositary receipts will cost about 7% of a client’s total exposure to U.S. equities. (That assumes the client wants a perfect hedge against any downside in U.S. equities holdings.)

If the client is willing to withstand, say, a 10% decline in the value of his or her U.S. equity assets, then the cost of insurance comes in at just 3.5% of the total portfolio value. The goal is to match the client’s ability to tolerate risk with the cost of the hedge.

You can find similar valuations in the Canadian market. One-year at-the-money put options on the S&P/TSX 60 index fund cost about 6%. That’s slightly less than the cost of insurance for U.S. equities – probably because of greater exposure within the Canadian economy to natural hedges such as gold and oil.

In the end, the decision to hedge in a client’s portfolio comes down to how best to address the client’s emotional baggage after giving due process to the client’s mandate.

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