With several equity markets near all-time highs, we posed a few questions to Ryan Hummer, a portfolio and risk manager at Ancora, to discuss and explain the role of hedging within dedicated alternative investment strategies, and some use cases in private wealth management.
Q: Ryan, you’ve spent your career around hedging and portfolio-level risk management. In a nutshell, how would you describe what hedging is and the role it can provide in a portfolio?
A: Hedging aims to reduce systematic, or macroeconomic, risk. Systematic risk, measured as beta, can be thought of as the tide that lifts or lowers all boats. With systematic risk reduced through effective hedging, a portfolio is left to primarily face just the idiosyncratic or business-specific risks affecting the stocks it holds.
Most, if not all, of our investors have portfolios that include a good deal of systematic exposure. In many instances, these beta-oriented return streams depend on whether the aforementioned “tide” of the markets is rising or falling. This is where hedged alternatives can come into play to help offset the systematic risks faced by a portfolio. Ancora’s alternative strategies largely seek to generate the lion’s share of returns through capturing alpha, or business-specific outperformance by the stocks we own, rather than through the overall market’s direction.
In general, such funds may have lower correlation to the overall market and therefore can be used as a tool to help reduce the overall volatility of an investor’s portfolio. These types of hedged strategies and lower-correlation return streams can help build a more diversified portfolio for the investor and capitalize on the only “free lunch” in investing: true, multi-asset class portfolio diversification.
Q: Can you describe the Wall Street infrastructure that allows for hedging? Who takes the other side of the hedge? Do they see the same risk differently?
A: The options market is very liquid and is becoming more so every year as interest and trading become more prevalent. Furthermore, the exchanges continue to roll out new contracts and products that make our ability to precisely hedge particular risks easier. Zero-day to expiration options are an example that has grabbed headlines lately. Wall Street banks make markets in these options, and the trading volumes are robust, especially in the largest stocks and the major indices. These banks or market-makers are typically taking the other side of these trades (if not, other investors who are taking an opposite view do), and the Options Clearing Corp (OCC) guarantees performance, so there is no counterparty risk for listed options.
The market-makers are able to hedge their option exposures through building long or short positions in the underlying instruments. They are typically trying to make a small spread on the bid-ask and then hedge out their directional exposure using a technique called delta hedging. They use this to limit directional risk in any single stock or index.
Q: What intelligence can the hedging markets provide that may help inform an investor’s other decisions in a portfolio? (excessive bullishness, bearishness?)
A: The options market does provide insight on sentiment and positioning that you cannot typically glean from other stock market or sentiment-related indicators. It can show when investors are complacent, chasing a rally they largely missed, when positions are full and need to limit risk or when the market is bombed out and full of fear.
One unique indicator I track is the S&P 500 Index (SPX) returns versus the Chicago Board Options Exchange’s CBOE Volatility Index (VIX), which measures the change in implied volatility of options on that index. Implied volatility is how options are priced. Typically, the VIX is down when the SPX is up and vice versa, but there are days when both the SPX and the VIX are up. When we see a series of days with both indices up, it may portend weakness in the coming months. Conversely, when we experience a series of days when both the SPX and VIX are down, that typically signals a near-term bottom.
Another example is option skew. Skew compares the implied volatility or price of out-of-the-money options versus at-the-money options. Normally, call skew is flat to downward-sloping, meaning out-of-the-money call options trade equal to or cheaper than at-the-money call options. When there’s a chase to the upside, or excessive optimism, we see out-of-the-money calls get bid up above at-the-money calls. In certain “meme stocks,” we’ve seen extreme call skew with far out-of-the-money calls trading at massive premiums to at-the-money calls.
Q: Within alternative investments, how can hedging contribute to lower correlated return streams compared to traditional stock and bond exposures? Any examples of where hedging lowered market correlations in recent memory, or is that something that has to play out over time to get a portfolio benefit?
A: A traditional balanced, or 60% equity / 40% fixed income, portfolio relies on a negative correlation between stocks and bonds in difficult times, but there is no guarantee that correlations will hold through all investment periods. In 2022, we saw the traditional negative correlation between stocks and bonds break down, and both asset classes lost money.
Hedges in our funds do not rely on correlations holding because they cover the markets to which our long book is exposed. 2022 was a great year to have exposure to true hedged strategies. This is why we consider the alternatives asset class to be an important “third leg of the stool” at Ancora. Over long cycles, hedged strategies may provide significant compounding benefits by preserving capital in down markets and reinvesting at better prices during both sharp and drawn-out bear markets.
Q: How are hedging applications similar or different in private wealth management than in a dedicated alternative investment strategy approach?
A: There are a number of ways hedging can be useful in the private wealth setting. Hedging can be useful for concentrated, legacy positions and overall portfolio exposure management. The IRS makes sure you pay taxes if you effectively sell your stock, so using options on an underlying stock to hedge will typically have negative tax implications. However, one can often find highly correlated ETFs on which options trade as a useful hedging tool. In certain situations, buying long-dated, out-of-the-money calls may also be an interesting strategy to gain hedged long exposure when speculating on future returns.
A call is equivalent to long stock + a put since you can only lose the premium paid for the call, but as previously mentioned, out-of-the-money calls typically trade at a discount to at-the-money calls, so this can create potentially advantageous skew if your directional view on the security or markets comes true. Bottom line, however, is that the key in any hedging or options strategy is to identify the problem you are trying to solve for and then find the best fit to address it via options markets.
Thank you, Ryan. If anybody has questions about hedging or the dedicated strategies within Ancora that utilize them, please reach out to your advisor.