Introduction
Stock market downturns are a regular occurrence, and they are part of every investor’s experience over time. Exposure to risk is what generates long-term returns—but it also requires investors to accept periods of volatility and temporary losses. This means having to stomach volatility and endure the pain of drawdowns.
When downturns happen, they can wipe out years of gains in a matter of weeks, but there are various hedging strategies available to protect your portfolio from heavy losses or at least to soften the blow. However, finding strategies that work reliably, without significantly lowering returns, is a challenge.
In this article we will look at and compare various portfolio hedging strategies.
Why Hedging Matters
Stocks take the stairs on the way up and the elevator on the way down – the Global Financial Crisis of 2008/2009 and the COVID-19 crash of 2020 were a stark reminder that even long market uptrends can end suddenly and violently. In March 2020, equity markets plummeted, volatility spiked, and even safe-haven assets were briefly sold off as investors rushed to cash.
A robust hedging strategy can reduce losses during such periods, help shorten recovery times and give investors the confidence to remain invested or even add risk in the aftermath of a crash. And even during good times, certain hedging strategies will reduce overall portfolio volatility.
Diversification Has Limits
Diversifying across asset classes helps manage risk, but it doesn’t eliminate it. Many “balanced” portfolios with allocations to both stocks and bonds still experienced sharp losses during major downturns. Correlations between asset classes usually rise in times of stress, reducing the benefits of diversification just when investors need them most.
Adding true hedges – assets that tend to rise when equities fall – can help fill that gap and offset losses in the underlying portfolio. These include safe-haven currencies, gold, and derivatives like put options. However, hedges come with trade-offs, most notably cost and sometimes reduced upside potential.
When Should You Hedge?
Hedging can be useful, but it isn’t free. Like insurance, it involves a cost. Therefore, it should be used strategically, not constantly. Some triggers that may justify adding a hedge include:
- Increased market volatility or a deteriorating outlook
- A portfolio’s exposure to a single risk factor becomes too high
- Rising probability of adverse market events.
- A need to protect a minimum portfolio value tied to liabilities or upcoming expenses or upcoming retirement.
A Hedging Framework
A useful framework for hedging was introduced by UBS using a hedging scorecard based on three key metrics:
- Sensitivity: Measures how much the hedge gains during market downturns relative to equity losses. A value of 1 means the hedge offsets losses completely.
- Cost: Reflects the opportunity cost of holding the hedge during calm markets. This is calculated as the average monthly return (excluding drawdown periods). Higher cost usually means higher sensitivity.
- Consistency: Captures how reliably the hedge worked across past market corrections. A score near 100% means the hedge delivered protection during nearly every downturn.
Hedging Categories
Hedges fall into two broad groups: proxy hedges and derivatives.
Proxy Hedges
These are assets that typically move opposite to equities during stress. They include:
- Government Bonds: Long-duration US Treasuries have historically offered excellent protection. But with yields near zero, their future hedging power is uncertain. Inflation-linked bonds offer some protection, but with less efficiency.
- Currencies: The US Dollar (USD), Swiss Franc (CHF), and Japanese Yen (JPY) often act as safe-haven currencies. USD has been the most consistent. CHF and JPY are less reliable due to central bank interventions and negative interest rates.
- Defensive Stocks: Stocks in sectors like consumer staples and healthcare tend to outperform during downturns. Pairing these with short positions in cyclical stocks can offer good protection—but at a cost during bull markets.
- Gold: Gold is a traditional hedge and has generated positive returns over the long term. However, its reliability in specific drawdowns (e.g., March 2020) has been inconsistent.
Derivatives
Put options and option structures offer direct downside protection. They can be tailored to deliver strong results in a crash but can be expensive.
Common strategies include:
- Vanilla Puts: Straightforward but costly. Require large market drops to offset premium.
- Put Spreads: Reduce cost by limiting protection to a defined range.
- Collars: Combine a long put with a short call. Offers cheaper protection but limits upside.
- Put-Spread Collars: Blend features of both, often providing the best cost-efficiency trade-off.
UBS evaluated each strategy on three equity indices (S&P 500, Euro Stoxx 50, SMI) and across two time horizons (3-month and 1-year) with the following findings:
- Long puts offer the highest protection but at the highest cost.
- Put spreads and collars lower costs significantly, with slightly reduced protection.
- Euro Stoxx 50 strategies showed the highest sensitivity due to the market’s higher volatility.
- One-year options generally offered better cost-efficiency due to slower time decay.
There Is No Perfect Hedge
No hedge works perfectly in all situations. Even historically strong hedges like US Treasuries may not offer the same buffer if rates are already at rock-bottom levels. The most protective hedges often come at a high cost, while lower-cost strategies may fail during the worst drawdowns.
Therefore, the best approach is diversification among hedges. Combining different instruments helps balance costs, reliability, and sensitivity. Investors can create a more resilient portfolio by using a mix of proxy and derivative hedges.
Using Hedges to Take More Risk (Safely)
With interest rates at historical lows, returns from traditional assets like bonds are shrinking. Investors seeking higher returns may need to increase their equity allocation. But more equities also mean more risk.
One solution is to hedge part of that increased equity exposure. For example, moving from a 60/40 portfolio to 80/20 (equities/bonds), while hedging 50% of the equity portion, can offer better returns while managing downside risk.
Backtested results suggest:
- This strategy slightly underperforms in bull markets (due to the cost of hedging).
- But during downturns, it cushions losses significantly.
- Over time, this leads to better risk-adjusted returns and lower volatility.
As bond diversification weakens (due to low rates and changing correlations), this kind of hedged equity exposure could become more important.
Conclusion
Diversification alone is no longer enough to protect portfolios from severe market drawdowns. Active hedging strategies are increasingly essential.
High-quality government bonds remain useful but may not deliver the same level of protection as in the past. Proxy hedges like safe-haven currencies or gold offer mixed results. Derivatives, while expensive, provide reliable downside protection.
The UBS scorecard helps investors evaluate hedges across three key dimensions—sensitivity, cost, and consistency – and highlights that no single hedge is best for all environments. The smart move is to blend different hedging strategies, applying the same principles of diversification that underlie good portfolio construction.
By combining insight, discipline, and a diversified mix of tools, investors can build portfolios that are better prepared to weather future storms without giving up long-term return potential.
In a follow-up post, I’ll walk through a hands-on example of how to hedge a portfolio consisting entirely of the SPY ETF using put options.