The recent stock market decline reminds us that risk happens fast. Bond values also dropped, meaning there was no diversification benefit between stocks and bonds, which further rattled investors’ nerves.
With the sudden resurgence in volatility, there has been, not surprisingly, a newfound interest in strategies that strive to hedge a portfolio against downside risk. These are known as absolute return strategies.
Before I became a wealth strategist serving select clients, I consulted leading wealth managers around the country on how to use absolute return managers that historically helped hedge a portfolio during bumpy times, or worse, periods like the Great Recession of 2008.
It fascinated me how financial advisors’ interest in hedging their clients’ portfolios spiked after a plunge in the stock market, which is tantamount to shopping for a seat belt after a crash.
In light of the recent market drop, I wanted to share how I’ve been incorporating absolute return managers for my clients over the last couple years in three different strategies.
I don’t offer boilerplate financial planning, so each client’s absolute return manager line-up is customized to fit their investment objectives and begins with one simple question: If the U.S. economy has a recession, would this negatively impact my client’s ability to fulfill their retirement goals?
1. Clients who are still earning income from executive positions, businesses they own, or real estate investments generally want to participate in economic growth but are not interested in beating the market.
For these clients, I’ve typically implemented 10% split evenly between long-short equity and merger arbitrage. Both of these strategies are inherently hedged with some short positions but are positioned to participate in continued economic expansion.
2. Retired clients generally have a stronger interest in wealth preservation because they would like to minimize downside risk. For these clients, I’ve implemented 10-15% split evenly between equity market neutral and merger arbitrage.
Equity market neutral managers should, in theory, have a net zero exposure to the stock market. E.g., if they own 100 stocks that they think will go up in value over time, they are also short 100 stocks they think will go down in value over time.
3. One additional strategy I’ve implemented for clients is hedged fixed income, often at 5-10% of the portfolio. In a rising interest rate environment, face values of bonds go down as interest rates rise.
We’ve been in a rising interest rate environment since the U.S. Federal Reserve started raising rates in 2015, which is why investors purchasing bonds or bond funds during this time frame may see their bond values in the red. Some fixed income managers can hedge by selling treasury futures short to alleviate some of the downward pressure on bonds as rates rise.
How I implement absolute return managers for each client is part art, part science and part stress testing; it relies on expertise from years of consulting leading financial advisors on how to use these strategies for their clients.
I don’t have a crystal ball but accept the reality that we may be in the late stages of this business cycle; as such, now may be the time to consider hedging your portfolio by implementing absolute return managers as satellite positions.
Vance Barse is a wealth strategist for high net worth individuals, families and business owners. Previously, for nearly a decade, he was an investment consultant to leading private wealth and retail financial advisors around the country. In that role, he managed relationships with advisors, RIAs and family offices. Sign up for Vance’s blog updates at vancebarse.com.