You could be forgiven for believing that the popular nursery rhyme Mary, Mary, Quite Contrary is an 18th Century lamentation on the downfall of English Catholicism, culminating specifically in the beheading of Mary Queen of Scots. But that, in our view, is an erroneous interpretation. Instead, the rhyme preaches sound investment management. Replace “garden” with “portfolio” and the line “How does your garden grow?” pertinently questions the means to reach that universally shared goal of all investors. The use of the word “garden”, however, importantly alludes to the important concept of “hedging”, the subject of today’s discourse.
Hedging is simply the practice of removing an identifiable risk from a portfolio. We have reflected previously that risk is not a singular quantum but is multifaceted: hedging allows an investor to specify exactly which risks they are unwilling to bear and gives the means to remove these. If silver bells are quality assets, then cockle shells are their choice protections.
Frequently the undesirable risk to be hedged is currency. For example, the return received by a UK investor owning a Japanese fund is determined by both the underlying investments and from the impact of changing exchange rates. In 2014 the Japanese TOPIX index rose by circa 8%, which was almost exactly offset by the 7% fall in the Japanese yen against the pound. Thus, in terms of pounds and pennies, an unhedged fund would have seen a somewhat disappointing return of around 1%.
To create a currency hedge, a fund manager could buy a futures contract that sets the exchange rate today for a conversion sometime in the future. In so doing, it matters not how the yen-pound exchange rate moves over the year, since our manager will be using their futures contract to convert their yen back into pounds. The exchange rate risk is removed; the portfolio is hedged.
A perfect hedge is particularly problematic to procure. Continuing our example, notice that when setting the hedge at the outset our fund manager does not know how many yen they will be converting back into pounds at the end: if the value of the portfolio rises, the extra profits will not be covered by the futures contract. In addition, hedges are not free: the cost of the hedge has to be charged to the portfolio whether or not it has worked.
Beyond currencies, there are many other risks an investor may wish to trim, including market risk. Perhaps a client with a substantial equity portfolio is worried about the near-term outlook for the stock market. This could be hedged by buying a put option. If the market falls, some of the losses in the stock portfolio will be offset by gains from the hedge, caveated by the difference between portfolio and the index (the tracking error). Alternatively, market risk can be hedged by buying some companies while simultaneously selling others; for example, buying BP and selling an equivalent amount of Shell. Given sufficient stock picking skills, this can generate positive returns regardless of general market movements. Indeed, this was the original defining stratagem that gave hedge funds their name.
The trim portfolio, so the rhyme informs us, wants its pretty maids all in a row. As a means to that end, hedging can be an important tool in the potting shed.