How to Explain Hedging Concepts to Clients

Bonds, which were the traditional hedge for stock portfolios, are no longer the convenient alternative.

INVESTORS TEND TO FALL into one of two broad groups: those who focus on how much they can make and those who focus on what they can lose. Most investors have an element of both in their approach, but one side of that tug of war usually outweighs the other.

When there are fever-pitched levels of investment speculation, as in the market today, investors can't be blamed for wanting to get a piece of the action. But since financial advisors usually prioritize discipline and planning over delivering the latest hot stock trend, they may find themselves in a tough spot with clients who want to reach for higher returns.

Often, the clients who are "in the clear" financially are the ones nudging you to do more. Instead of deflecting, you can convert that conversation into a valuable learning and bonding experience, and an opportunity to introduce them to hedging.

They may say something like this: "I know we need to be conservative, and that's great. But my friends are all doing so well with XYZ, ABC and their other investments."

Now, you have two choices in your response. The first choice: You can explain to them that their friends are probably stretching the truth and risk seeming like you are making excuses. Or you can help them embrace their inner fear of missing out, or FOMO, while continuing to protect their assets. In this case, the concept of hedging comes in handy.

Here's how to explain hedging to your clients.

Set the Stage for a Pointed Discussion About Hedging

Help your clients remember what they may have forgotten: that the most consistent thing about stock market returns is that they are not consistent at all. They are highly cyclical. For instance, since 2000, the average one-year return of the S&P 500 index, including dividends, was about 7.8%. However, to achieve that "typical" long-term return, investors experienced one-year returns ranging from a gain of more than 50% to a loss of more than 40%.

Help them remember what they may have forgotten when surrounded by all of the recent financial hype. That sets the stage for a more pointed discussion about if and how to include hedging in their investment plan.

Explain That Hedging Has Little in Common With What Hedge Funds Do

The original hedge funds were simply looking to offset the risk of their stock positions by shorting other stocks they found unattractive. Today, by comparison, the hedge fund business is loaded with leverage, speculation and attempts to capitalize on specific information and events. That is not hedging. Hedging is specifically about removing risk from your main investment portfolio.

Liken Hedging to Insurance

You can compare hedging to the property-casualty insurance business. No one knows, for example, when or if their house will catch fire. But nobody wants to be on the hook for the damages. That gives most people an incentive to use a modest portion of their wealth to offset that risk with insurance.

Hedging a portfolio is similar, except that the process is more fluid and liquid. Hedging can be increased or decreased at will, using exchange-traded funds or other daily liquid assets. And hedging does not have to be a temporary exercise. For many investors, portfolio hedging can fit seamlessly into their long-term investment regimen. It can be as central to their asset allocation as their core stock portfolio.

Relate the State of Bond Investing

Perhaps the best reason to put "hedge-ucation" at the front of your 2021 client advisory agenda has nothing to do with the nosebleed heights reached by many corners of the stock market. It has more to do with what bonds are no longer doing for your clients.

They may be surprised to learn that bond investing has been in a state of perpetual high risk due to low interest rates, the threat of inflation and how bond math works. Bond funds that yield 1% to 2% offer little upside versus their potential downside risk.

If rates rise, bond income does not cushion price erosion the way it used to. Even if rates fall toward zero again, that is not necessarily a healthy sign for financial markets. So bonds, which were the traditional hedge for stock portfolios, are no longer the convenient alternative. Research different hedging options to help you map out the strategy that's best suited to your client's investment objectives.

Key Reasons to Use Hedging Techniques

Consider these three key motivations for hedging. They can serve as a starting point for your research, so you can map different hedging techniques against different types of client investment objectives.

Lower stock market exposure. Whether you add short, or "inverse," equity exposure via ETFs or mutual funds, or simply hold more cash or short-term Treasury securities as a percentage of portfolio assets, the goal here is to win by not losing.

At this stage of the equity bull market, clients may have more stock market exposure than they truly need, given the potential for lower long-term returns. The classic response is to rebalance stock exposure into bond exposure. However, as noted previously, that is not the source of diversification it used to be

Instead, consider investing a portion of the portfolio in something that goes up when the market goes down, such as inverse ETFs. Do some research on these and other investments to learn how different products are created. Keep in mind that rising interest rates can be hedged through certain inverse ETFs as well. So both stock bubbles and low bond yields can be dealt with by hedging.]

Make an investment portfolio more all-weather. To achieve this, add assets that are not tethered to stock market performance, such as commodities and currencies. You can also embrace tactical investment techniques to capitalize on the increasingly short-term nature of security price movements. Either way, the goal here is to get more in sync with the markets of 2021 and back away from the traditional asset allocation approaches that no longer function as they once did.

Turn investing defense into offense. Once you have incorporated some of the techniques above, you can try a strategy that few in the financial advising industry use, but probably should. That is, add a dimension to client portfolios that not only aims to clamp down on the impact of a falling stock or bond market, but also positions them to capitalize on extreme market turmoil, or "tail-risk events." There is an entire breed of ETFs that is designed to not only defend, but also offer a fighting chance at a profit, in a wide variety of market conditions.

Examples of these ETFs include the Cambria Tail Risk ETF (ticker: TAIL), Aptus Defined Risk ETF (DRSK) and ProShares VIX Short-Term Futures ETF (VIXY).

Hedging does not automatically reduce investment returns. This is more likely the case in a runaway bull market for stocks. However, one of those has just passed. And with the reality of flat or negative returns looking more likely by the day, there may never be a better time to explain hedging and its potential benefits to your clients.