Embrace the Simplicity of Hedging

August 2024

The inflation-fueled market sell-off in has spurred much debate over the future of multi-asset diversification. In our opinion, the events of August 2024 only underscore the challenge of managing portfolios in periods of volatility, as a sharp equity market reversal buffeted investors. In the face of such uncertainty, Capstone believes that focusing on intricate details of portfolio construction overlooks a simpler solution. Rising markets and increasing investor risk appetite have driven ¹, which may provide an exceptional opportunity to protect against market tail risks. Despite the recent market turbulence, the silver lining is that while such a shock would normally suggest prospective hedgers had missed their chance the swift easing of volatility means investors may still have time to secure .

What is Portfolio Diversification Trying to Achieve?

Multi-asset investing hinges on the belief that holding various assets that perform differently across market cycles will help mitigate drawdowns. The experience of 2022 has shown, however, that when assets move in lockstep, the negative impact on portfolio performance can be dramatic. Much has been written about how investors should adjust portfolios to deal with a secular change in asset class correlations, whether through rebalancing equities and bonds or identifying new assets to assume the traditional role of bond holdings. While these approaches have merit, our view is that if investors know the tail risks they are trying to mitigate, then buying insurance against those risks directly can offer greater certainty and improve long-run portfolio performance.

Volmageddon 2.0? August Sell-Off Recap

We believe that recent market events have made a strong case for hedging. Geopolitical tensions and weak data caused the equity market to stall in mid-July. At the start of August with US equities down, weaker US macro data and nerves in Japan exacerbated the market correction, especially given the fragile combination of extreme positioning and thin summer liquidity. This drove extreme spot moves in the Nikkei and a ferocious spike in short-term US equity volatility. The centre of the storm was the VIX Index, which recorded its largest one-day upward close-to-open gap on the morning of August 5th. Those looking for a culprit highlight the growth in option-selling programs that leave dealers heavily exposed to a sharp downward spot move, forcing them to buy downside options or upside VIX exposures to hedge in a hurry. Despite the stress, by the close of trading on August 9^th, US equity markets had made back their losses and as of August 19^th were back near all-time highs. While bonds generally experienced some gains over the prior weeks, amid all the drama on August 5^th, US Treasuries rose a paltry 0.1% (or 0.5% when looking at just long-dated bonds). Such a muted response from bonds does not provide confidence that they will serve as a strong risk offset in future moments of equity stress.

Rarely a Better Time to Protect the Tails

Tail risk hedging is often naively dismissed as expensive due to the persistent risk premium demanded by option providers. However, we believe it can be an effective way to preserve capital for portfolios to benefit from long-term compounding and potentially avoid permanent loss of capital. Furthermore, in mid-2024 the cost of hedging touched its lowest levels in , generally driven by falling implied volatility levels and high interest rates. History suggests that such attractive hedge costs are unlikely to last, making equity hedging a timely and cost-effective solution for investors seeking to address a loss of portfolio diversification.

¹As measured by a one-year maturity, 90% strike European put option on the S&P 500 Index.

I Told You So?

Recent cooling of inflation and talk of interest rate cuts gave investors hope that markets would revert to pre-Covid normality. The turbulence experienced at the start of August has bluntly proved them wrong. The -3% drop in the S&P 500 on August 5th was the largest daily drawdown in two years, and bonds were unmoved on the day despite a modest rally since the equity peak in mid-July. The VIX Index told a different story, surging 15 points by market close in its seventh largest one-day move on record, with an even larger intraday move observed. A simple equity protection strategy of owning one-year 90%-strike puts on the S&P 500 during the move on August 5^th would have delivered +1.3% in a single day, offsetting almost half of the equity loss. In July, just one month prior to the sell-off, such insurance was available for a mere 2% of equity value for a year of protection. More sophisticated protection strategies with direct exposure to market volatility could have generated returns many multiples higher, highlighting how tail hedges can provide the positive convexity required to protect portfolios against market shocks for a modest price.

Have Investors Missed Their Chance?

The events of early August are not unprecedented – historic lows in hedging costs have preceded equity shocks over multiple periods of crisis such as the 2007-2008 Global Financial Crisis and Q1 2020 Covid pandemic. If a sell-off becomes prolonged, hedging costs typically remain elevated for an extended period. For example, it took more than two years for put pricing to revert back to pre-Covid levels after the 2020 pandemic. Fortunately, for now, in our view, the market seems to have shrugged off the risk of further stress, and hedge costs have quickly reverted to below where they started in 2023. As a result, we believe there is still time for investors to take advantage of the current opportunity.

The Value of Certainty in Unpredictable Times

There is no doubt that the world has changed following the unprecedented fiscal and monetary response to the Covid crisis. We believe the impact on global markets is likely to persist, now presenting investors with historically difficult asset allocation challenges. In such an environment, is immensely valuable, and Capstone believes that protecting equity tails can be done simply and without incurring prohibitive costs. While multi-asset diversification remains a cornerstone of portfolio management, the recent market volatility underscores the importance of implementing a more straightforward and reliable protection strategy. After all, sometimes the simplest solutions are the most effective.