The benefits of hedging in 2023

One investing expert is highlighting how a portfolio's volatility can be reduced via an equity hedge to give protection against shocks, and over time, lower volatility may lead to higher wealth.

In a recent commentary for AGF Investments, Bill DeRoche, head of Quantitive Investing, wrote that unsurprisingly, investors who used anti-beta equity strategies fared quite well in 2022. He noted that these strategies are designed to perform well when the stock market is underperforming, and 2022 was a terrible year for stocks.

Currently, investors are hopeful that 2023 would offer relief from the punishing interest rate increases implemented by central banks as well as a rebounding stock market. Many may also believe that equity hedging will no longer be a successful tactic.

But in his note, DeRoche outlined several reasons to think that anti-beta hedging strategies, which usually aim to sell stocks with larger betas and go long on stocks with lower betas, will remain crucial instruments to combat market risk and volatility in 2023.

One is that a considerable number of questions still need to be answered before the stock market's risk level can start to decline. The most significant is the current level of interest rates; U.S. Federal Reserve officials have made it plain that they believe rates will peak between 4.75% and 5%, but over the past few months, those projections have been routinely pushed upward.

Furthermore, the demand decrease the Fed seeks to produce may take longer than markets predict due to strong consumer balance sheets and low unemployment. In 2023, it is also conceivable that there won't be any rate cuts.

Uncertainty over how severe and prolonged a recession, which appears very likely, may be more damaging. The next recession may last longer but may be less severe than the most previous shock-induced downturns, namely COVID-19 in 2020 and the housing crisis of 2008.

According to DeRoche, equity markets could be anticipated to reach their bottom far before the conclusion of the upcoming downturn, even if they do tend to "see through" recessions to recoveries. However, this year’s excessive volatility – according to calculations using Bloomberg data, has been around 50% higher in 2022 than pre-pandemic – could also be anticipated to persist until that end is in sight.

According to DeRoche, an anti-beta equity hedge performs very well in two situations: when stocks decline and when interest rates are increasing. This is mostly because the short high-beta element of the portfolio often has a considerably longer duration than the long low-beta portion.

“When considering hedging, investors need to ask how much risk they are willing to take on,” DeRoche says. “Volatility creates significant sequence risk – that is, the risk that market shocks create significant draw-down events at particular points in time.”