With the markets heading for a potential downturn, investors are trying to determine the best strategy to use to hedge against falling markets.
What’s Inside?
The strategy that best protects declining asset values is less evident than it may appear. And the options available to protect asset values seem to be shrinking.
How Is This Article Useful to Practitioners?
Investors are worrying about the possibility that overvalued US markets are due for a correction, and they are considering how best to protect against a downturn. Equities are more overvalued than they have been in 15 years; bonds appear to have achieved record valuations as well.
AQR, a fund management firm, studied the 10 worst quarters for global equity and government bond markets over a 42-year period. The firm found that because of the complementary nature of stocks and bonds in a portfolio, they tend to offset each other’s risks and are unlikely to decline in equal measure in a falling market. Commodities, gold in particular, have also served as a useful hedge in down markets. In contrast, corporate bonds underperform government bonds in falling stock markets. Moreover, the record for equities is mixed when government bond prices decline; they posted increases in only 6 of the 10 worst quarters.
Hedge funds have lost an average of 5.2% in the eight down quarters for equities since 1990, which is when indexes to track them first became available. AQR contended that investors should not treat all hedge funds alike because a combination of strategies, such as value, momentum, carry, defensive, and trend following, would have held up well in past equity market downturns. A caveat about AQR’s research is that the firm has used back-testing to examine how an allocation of these strategies would have performed in the past. Otherwise, positive results can be a function of data mining.
Investors should not try to time the markets or worry about short-term market drops. Over the longer term, asset prices have always risen. Rebounds from both the dot-com bubble and the recent crisis attest to their resilience.
It is possible the markets may frustrate investors with a slow, protracted decline, such as what Japan has experienced over the past quarter century. Its stock market remains at half its 1989 value, and bond yields have produced insignificant rates since the late 1990s. A long, slow drop could permeate developed world markets. Emerging markets were once considered a good hedge, but they have proven to be a disappointment recently.
Market strategists and financial advisers, as well as portfolio managers and policymakers, should consider the consequences of market declines and generally lower growth around the world.
Abstractor’s Viewpoint
Global financial markets still offer opportunities for investors to make money and protect against market declines. The question is what and how pervasive the nature of such declines will be. A clearer understanding of possible conditions should inform how best to plan for them, which is no small challenge in a world of dwindling opportunities.