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Citation - Third Quarter 2022

INSIGHTS

HEDGING AS AN INVESTMENT STRATEGY

VINCENT MASOLOKE
Investment Strategist and Portfolio Manager
Estimated reading time: 2 minutes 52 seconds read

At Citadel Asset Management, our main objective is to grow the value of our clients’ assets over time, while always managing risk. It is well understood that the economy fluctuates between periods of expansion or growth and contraction or recession, and this can pose significant risks to the value of our clients’ portfolios.

Typically, in periods of expansion the value of financial assets grows, and the opposite is true in periods of contraction. Other external factors also affect the financial markets negatively. COVID-19 is a classic example, where in 2020, markets suffered a horrible drawdown (decline), due to the unforeseen ramifications of the pandemic. The ongoing Russia and Ukraine war is another example of external factors affecting financial markets negatively.

Without trying to be exhaustive, unexpected negative economic data, social and political unrest, and local and international elections are some of the other factors that also create uncertainty in the financial markets. These uncertainties create elevated levels of risk, and in turn, increase the possibility of financial assets declining in value.

To protect the capital value of our clients’ portfolios from market risks, we make use of a powerful tool called hedging. The best way to understand hedging is to think of it as a form of insurance. When portfolio managers decide to hedge, they are insuring against the impact negative market conditions can have on assets under management. This does not prevent the negative event, but rather reduces the effect of the event on investments. Hedging is also an excellent complement to diversification.

The key takeaways of hedging are as follows:

  • Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset.
  • While hedging reduces a portfolio’s risk, it can also have the effect of reducing the portfolio’s potential returns.
  • Hedging requires the investor to pay money for the protection it provides, which is known as a premium.
  • Hedging strategies typically involve derivatives, such as put options and call options, and futures contracts.

Our portfolio managers are always seeking ways to protect client portfolios in periods of extended downturns, like the one we have found ourselves in since the beginning of 2022. The best outcome is for a hedge to act as a buffer and offset part of the decline in, for example, equity markets or to mitigate adverse moves in exchange rates.

One of the main benefits of hedging – within a portfolio context – is that, although paying away some premium, the investor does not have to sell the underlying asset to reduce exposure to that asset. This is important because it creates an asymmetric payoff profile, which provides downside protection, without sacrificing upside participation. There are alternative structures which allow the investor to hedge for zero cost, but this often comes at the expense of full upside participation in the underlying asset’s return.

Derivatives often have a bad reputation in the markets because of the incorrect application and use of this portfolio-insurance tool and because some market practitioners, who have little understanding of the tool, use them for speculative purposes.

On the flip side, making use of derivatives for efficient portfolio management remains an extremely valuable part of our process. It links back to one of our core investment philosophies; that the future is uncertain, and it will surprise. At Citadel Asset Management, we ensure we protect against those surprises, as much as possible.