In this listener requested episode, we look at where, and if, hedging should be part of your investment strategy.

The concept of hedging is to remove a particular risk from a portfolio. The episode goes through how investors achieve this through financial products and investment strategies, with examples. However, it also addresses the misconception that hedging is diversification.

There are a lot of investors that think that diversification is having assets that are negatively correlated. That means when one asset goes up, the other goes down. This is often used in very simplistic descriptions of shares and bonds in a portfolio. Some people believe that when shares go up, bonds go down and vice versa. This just isn't true.

Not only is it not true, but this is not what any long-term investor actually wants. Shares and bonds move in the same direction over the short term all the time. Over the long term, from a return perspective, they both tend to have positive returns. In other words, they move in the same direction. Shares are just more volatile, which means they bounce around in price more. Bonds tend to bounce around in price less, but they do bounce around and can go down, can and have gone down, sometimes meaningfully. The point of including bonds in a portfolio is not because they move in the opposite direction of the share, it is because they are less volatile. them in a portfolio makes the whole portfolio less volatile.

Over the long term, most investors don't actually want negatively correlated assets in their portfolio. Having an asset negatively correlated to shares, which make up a good deal of most investors' portfolios, isn't a good idea because over the long term, shares have historically gone up a lot, which means a negatively correlated asset will go down over the long term.

If an investor wants to lower volatility, buy an asset like a bond or keep money in cash, where returns are positive over the long term. Stop trying to look for negatively correlated investments to diversify your portfolio unless you think shares are going to have negative returns over the long term.

Listen to the full exploration of hedging, as well as alternatives that investors should consider in the episode.

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You can find the transcript for the episode below:

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into account your personal situation, circumstances, or needs.

Mark LaMonica: Alright, Shani. So hopefully we have an interesting topic today. We always try to make them interesting. We're going to talk about hedging, and that is a rather broad topic.

Jayamanne: But we're going to try and break it down and make it useful for everyone listening that is trying to achieve your goals. So why don't we try to start with the definition?

LaMonica: Okay, so I Googled hedging, Shani. And the definition I got was the planting or trimming of hedges.

Jayamanne: We've been talking about our survey. I feel like a lot of the results that we got, some people were very, very complimentary. It was all quite nice, but a lot of people said that they don't really like your humour.

LaMonica: Yes, cringe-worthy, I believe was the word that was used. But we would like you to fill out...

Jayamanne: I echo their sentiment.

LaMonica: Yeah, we would like you to fill out the survey. So please do that. And I will say that one of the responses is someone described Shani's voice as sensual.

Jayamanne: They did, and someone again said that you sound like Fozzy the Bear. So, there was that.

LaMonica: Okay, well, Shani is blushing at the sensual part.

Jayamanne: Can you see me blushing?

LaMonica: So why don't we get back to hedging? So, the real definition of hedging, at least how we're going to talk about it today, is a risk management strategy employed to offset losses and investments by taking an opposite position in a related asset.

Jayamanne: Investors use hedging to remove specific risks from portfolios, but not all risks. Hedging allows investors to keep certain risks, and that's important. It's taking a risk that generates returns. So, with hedging, we get to focus on the risks we want to take.

LaMonica: So, we'll talk about how you hedge and then go through a couple examples. So, to remove a risk from a portfolio, we need to include an asset that moves in the opposite direction as another asset in the portfolio. Now, these assets that move in the opposite direction don't generally just naturally occur in the investing world. They need to be created.

Jayamanne: And today, we'll be mentioning derivatives a lot. And some investors may have heard of derivatives but might not be too familiar with them. A derivative is simply a financial instrument that derives its value from another asset.

LaMonica: And these instruments include futures, forwards, options, swaps, warrants. And basically, these are just contracts between two parties to exchange two things of value. This could be a contract to exchange money based on how a different asset performs. Some of these contracts are customized between two institutions, and some go through an exchange where there's more structure and uniformity in the contracts. But either way, they work in similar ways.

Jayamanne: And there's one way to hedge a portfolio that isn't done using derivatives. That's taking a short position. When you take a short position in a share, for example, you borrow shares from someone who owns them and you sell them, so you get the cash. But at some point, you'll need to give them back and you have to buy them back. If the prices go down, you buy them for less than you sold them. If the prices go up, you buy them for more than you sold them.

LaMonica: And just to be clear, you do need to go through a broker for this whole process of lending and borrowing shares. So, you don't just wander around the pub and ask somebody if they have 100 CBA shares.

Jayamanne: We've talked about the jokes, Mark.

LaMonica: Okay. I am sorry. No more jokes. It's going to be serious from now on.

Jayamanne: Some people did ask for that.

LaMonica: For it to be serious.

Jayamanne: Yes.

LaMonica: Okay. Well, they'll be happy with the rest of this episode. But we do want to be clear about shorting and derivatives. They can be used for hedging, and they can also be used for speculation. To use them for speculation, you don't hold the underlying asset and are just making a directional bet on something. Hedging means you're removing a risk of something that's already in your portfolio.

Jayamanne: We promised examples, Mark. So, let's walk through two. The first is a market neutral fund. A market neutral fund takes long and short positions, which is the goal of removing market risk from a portfolio. With market risk gone, the fund looks to profit from making specific calls on the relative performance of securities. That way, if the manager does well, the fund should generate positive performance and that is if the market falls or if the market rises. For example, a manager could decide that Westpac will perform better than CBA. The manager will go long Westpac and short CBA. So, it doesn't really matter if both Westpac and CBA go up or both go down. It just matters that Westpac does better than CBA. So, Mark, why would an investor pick a market neutral fund?

LaMonica: Well, I mean, I think maybe a good place to start is saying that most investors shouldn't go anywhere near a market neutral fund. We are, of course, proponents of taking a long-term view on markets. And over the long term, the market has historically gone up, which means that over the long term, it makes no sense to remove the market risk from a portfolio because you're also removing the long-term trend that makes markets go up.

Jayamanne: I can see Will like out of the corner of my eye gearing up the music and the background for your rant.

LaMonica: You know, this is supposed to be serious, remember?

Jayamanne: Yeah, sorry.

LaMonica: Okay. Well, I'm sort of half done with my rant.

Jayamanne: Okay.

LaMonica: But it's a serious one. So, what you've essentially done is you've removed market risk, but instead you are making a bet that the manager is able to determine which shares will relatively outperform other shares. In the example of a market neutral share fund, of course. And in a way, that is what every manager is doing. So, most managers, of course, wouldn't short the share that they think will underperform. They just don't buy it. Well, we need to remember that most managers underperform the index over the long term. And by taking a short position, these market neutral funds are increasing the downside risk if they are wrong. Just doesn't seem to make a lot of sense to me.

Jayamanne: And I guess that settles that. So, let's move on to our next example.

LaMonica: Which I think is more relevant to people listening to this.

Jayamanne: Yes, I think so. And this was a listener requested episode. And when they sent the email, they asked for an episode on hedging. And I think this is what they were talking about.

LaMonica: Hopefully.

Jayamanne: Yes. So, ignore the first part of the podcast that we were just going through, but we are going to talk about hedging in relation to currency risk. When you invest in global shares, you're exposed to the performance of whatever you're investing in. Let's say U.S. shares, and you are exposed to changes in currency that will add or detract from returns.

LaMonica: And just as a reminder, if you are an Australian investor who is investing in U.S. shares, you want the Aussie dollar to get weaker against the U.S. dollar. That will add to returns. The Aussie dollar gets stronger against the U.S. dollar. It will detract from returns.

Jayamanne: And in this case, derivatives are used to hedge the impact of changes in currency. But for an investor interested in hedging their global exposures, this is actually quite simple. Many ETFs that invest globally come with a hedged or unhedged version. And we can use an example. One very popular ETF that tracks the S&P 500, which represents the 500 largest U.S. listed companies, is the iShares product with the ticker symbol IVV. That ETF will track the performance of the S&P 500 but will also be impacted by the changes in the U.S. and Aussie dollar. And there is a hedge version with the ticker symbol IHVV.

LaMonica: So that ETF, IHVV, will perform exactly the same as IVV, but with movements in currencies removed. Now, if we go and we look at the last five years, IVV has delivered returns of 16.3% a year, which is very good. IHVV has delivered returns over the same five years of 12.22% a year, which I guess I would add is also very good. That difference of a little more than 4% a year is the Aussie dollar getting weaker.

Jayamanne: So, who would we consider the hedged version for, Mark?

LaMonica: Okay, well, I think there's two ways to think about this. The first is that if you are making a directional bet on currency movements, so for whatever reason, you think the Aussie dollar will appreciate or depreciate against the U.S. dollar, and then you buy the appropriate ETF based on that view.

Jayamanne: And we do need to say that there are lots of factors that influence the relative performance of currencies. There is a global geopolitical situation. There are relative levels of interest rates and inflation, just lots of factors. So, getting this right is hard. And the last thing we would ever advocate for is an investor switching between two ETFs. So, you kind of need to pick one and stick with it to avoid all the things that detract from long-term returns, including taxes and transaction costs.

LaMonica: Yeah, and that's certainly true. Another thing we encourage everyone to be is a long-term investor. So really, when you're making these directional bets about currency movements, you're making them over the long term. And that's not an easy thing to do. So, all of those factors will play out over hopefully decades if you're a long-term investor. And of course, there'll be fluctuations along the way between the currency. So, to reiterate what Shani said, we would suggest you just pick one and stick to it.

Jayamanne: And the other thing that we advocate for on this podcast is to make investment decisions based on your own personal circumstances. So how can an investor think about this?

LaMonica: Okay, so this is really complicated when it comes to currency movement. So, we are all impacted in different ways, many of which we don't even realize by changes in currency. I've actually thought about my own circumstances, which are probably somewhat unique. And I have a hard time deciding what the right call for me would be. So, I own shares in the U.S. and I own property in the U.S. both of which kick off cash flows. So, in theory, a weakening Aussie dollar is beneficial to me as it makes those cash flows higher in Aussie dollar terms. But conversely, I have expenses in the U.S., like taxes and traveling home annually, which would be cheaper in Aussie dollar terms if the Aussie dollar appreciated.

Jayamanne: Your mum's going to play back this podcast according to you if you do not travel back annually now. You've said it.

LaMonica: I know, but maybe another pandemic will hit, and the borders will be closed. Anything could happen.

Jayamanne: Okay, so what is your conclusion, Mom?

LaMonica: Well, I mean, ultimately, if I was investing in ETFs that held U.S. assets in my Australian brokerage account, and I will say this is something I've not done since I have a brokerage account in the U.S., I would probably hedge them to protect the value of my overall cash flows in case the U.S. dollar plummeted. But I also don't think it's a long-term call that is critical to achieving my goals.

Jayamanne: So, I think more than anything, think about how this is going to impact your life. But remember that consistency is more important than constantly making bets one way or the other on currency movements. And remember that currency movements are going to impact the underlying companies as well. Changes in the U.S. dollar will impact U.S. companies in both positive and negative ways. As we said, this is complicated.

LaMonica: Okay, so let's move on to one last related topic. So, we've covered hedging, so removing a particular risk from a portfolio. But one thing that I've observed is that investors confuse hedging with diversification. And these are two very different things.

Jayamanne: There are a lot of investors that think that diversification is having assets that are negatively correlated. And that means when one asset goes up, the other goes down. And when we hear this the most is in very simplistic descriptions of shares and bonds in a portfolio. Some people believe that when shares go up, bonds go down and vice versa. And this just isn't true.

LaMonica: And not only is it not true, but this is not what any long-term investor actually wants. Shares and bonds move in the same direction over the short term all the time. And over the long term, from a return perspective, they both tend to have positive returns. In other words, they move in the same direction. Shares are just more volatile, which means they bounce around in price more. Bonds tend to bounce around in price less, but they do bounce around and can go down, can and have gone down, sometimes meaningfully. The point of including bonds in a portfolio is not because they move in the opposite direction of the share, is because they are less volatile. And putting them in a portfolio makes the whole portfolio less volatile.

Jayamanne: As Mark said, over the long term, most investors don't actually want negatively correlated assets in their portfolio. And what he means by that is over the long term, having an asset negatively correlated to shares, which make up a good deal of most investors' portfolios, isn't a good idea because over the long term, shares have historically gone up a lot, which means a negatively correlated asset will go down over the long term.

LaMonica: That's right. So, if an investor wants to lower volatility, just buy an asset like a bond or keep money in cash, where returns are positive over the long term. Stop trying to look for negatively correlated investments to diversify your portfolio unless you think shares are going to have negative returns over the long term. If you do think that, then you probably shouldn't own them in the first place. And even if an asset responds in a negatively correlated way over the short term, yes, that will prevent you from getting some losses. But ultimately, as a long-term investor, you want to focus on those total returns over the long term. All right so that was our listener requested episode. Hopefully, it answered the question. If whoever requested that, if that did not answer your question, I guess write back, we'll do another hedging one. And this time, we'll make it serious from the beginning.

Jayamanne: That's a good idea.

LaMonica: All right. Well, thank you very much for the people that did fill out our survey. We would love some more responses. So, fill it out. You will be entered into winning that $250 Visa gift card. And you'll also make us happy. What's better than that? So, thank you very much for listening.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)