Dealing with Doomsday: 3 ways to hedge against a worst-case market scenario | BetaShares

Dealing with Doomsday: 3 ways to hedge against a worst-case market scenario

BY David Bassanese | 27 August 2019
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Dealing with Doomsday: 3 ways to hedge against a worst-case market scenario

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Given the ongoing trade war and slowing global growth, many investors are understandably concerned about the market outlook.  While I feel a ‘doomsday’ scenario is unlikely anytime soon, this note nonetheless considers what investment options might be of interest to those investors who hold grave concerns – and are seeking portfolio hedges against negative market outcomes.

Diversification – a good idea in any market environment

One of the ‘free lunches’ in investment markets is portfolio diversification. By including a range of different exposures in one’s portfolio, that perform differently in different market environments, investors can improve risk-adjusted portfolio returns over time.

Even in bull markets, investors know they should spread their equity risk across a number of companies – and ideally industry sectors and countries/regions too.

For those wishing to reduce downside risk in the case of ‘doomsday’ scenarios, it’s a good idea to seek investments that may perform well when equities do badly.

In the current market environment, three investments worthy of consideration are: short funds, gold and government bonds.

Short Funds

Short or Bear funds are designed to go up in value when equity markets go down (and vice versa). They seek to offer negative correlation to equity returns over time.

BetaShares offer three Bear funds, two covering the Australian share market and one covering the US market.

The BetaShares Australian Equities Bear Hedge Fund (ASX Code: BEAR) is designed to deliver a return of between 0.9% and 1.1% on any given day in which the Australian share market declines by 1% (and vice versa)1.

For investors seeking magnified negative exposure to the market, BetaShares Australian Equities Strong Bear Hedge Fund (ASX Code: BBOZ) is designed to deliver a return of between 2.0% and 2.75% on any given day in which the Australian share market declines by 1% (and vice versa)2.

BBOZ has provided negative correlation with the Australian equity market since its inception in early 2015.  For example, in late 2018, when the market total return drawdown reached -12.9% by 21 December 2018, BBOZ returned +39% over the comparable period.  Of course, if the market goes up, short funds can be expected to go down.

Similar magnified short exposure to the US equity market is available through the US Equities Strong Bear Fund – Currency Hedged (ASX Code: BBUS).

Note, however, that given equity markets tend to trend up over time, returns from short funds are more likely to turn negative the longer they are held. Therefore, the appropriateness of holding a short fund should be reviewed frequently.

Additionally, in the case of BBOZ and BBUS, gearing magnifies gains and losses and therefore may not be a suitable strategy for all investors.

For investors seeking longer-term risk mitigation strategies within their portfolios, maintaining an appropriately diverse asset allocation calibrated to their risk-return preferences might be more appropriate.

 

Gold

Depending on the market environment, gold can serve as a useful source of downside protection in times of equity market decline.

In times of very high inflation, when returns from both bonds and equities may be hurt by rising nominal interest rates, gold could benefit from the broader rise in global inflation expectations.

As seen in the chart below, even in today’s relatively low-inflation environment gold has tended to rise in periods of equity market weakness, as such ‘risk-off’ periods have been associated with heightened expectations of even more global monetary stimulus and currency instability. Today’s low interest rates have also generally reduced the opportunity cost of maintaining some exposure to gold within portfolios.

The BetaShares Gold Bullion ETF – Currency Hedged (ASX Code: QAU) provides exposure to the $US spot gold price by investing in physical gold bullion on a currency-hedged basis.  Investors also have the option of gaining gold exposure through the BetaShares Global Gold Miners ETF – Currency Hedged (ASX Code: MNRS).  Some investors find gold miners to be an interesting proposition over the long term, as even in a period of relatively stable or potentially softer gold prices, many leading global gold miners may still find they can generate profits and offer returns to investors.

As might be expected, gold mining companies have tended to do relatively well in periods of gold price strength – as evident in the chart below, which shows the performance of the index MNRS aims to track.

Government Bonds

Due to the relatively high credit rating of Federal and State Governments, along with the prospect of monetary stimulus in times of equity market weakness, government bonds offer another potential source of downside portfolio protection in doomsday environments.

In times of equity market weakness, for example, market interest rates tend to fall – which in turn boosts the market value of fixed-rate government bonds as the present value of their stream of fixed nominal income payments tends to rise (and vice versa).  This tends to create a negative correlation between equity and fixed-rate government bond returns over time, meaning the latter offer potential for downside protection when equity markets are in retreat.

The BetaShares Australian Government Bond ETF (ASX Code: AGVT) provides exposure to relatively long duration3 fixed-rate bonds mainly issued by Australian Federal and State Governments.  As seen in the chart below, due to declining market interest rates over the past year, the index AGVT aims to track has returned 15.1% over the twelve months to end-July-2019.

Due to slowing in both Australian and global economic growth over the coming year, I anticipate the Reserve Bank of Australia will cut official interest rates from the already low rate of 1% to 0.5% by February next year.  What’s more, the RBA could well also engage in some form of local quantitative easing if need be, which would involve actively buying government and corporate bonds in the market to drive down longer-term bond yields even further.

Both these scenarios are even more likely in a ‘doomsday’ environment, which would likely further bolster the return from government bond exposures such as AGVT.

Note: Historical performance shown above is not indicative of future performance.


1.To achieve this result, the Fund maintains a short exposure to the market through the sale of equity index futures contracts (i.e. ASX SPI 200 futures) broadly equal to the value of invested funds.

2.Compared to the BEAR Fund, this magnified negative equity exposure is achieved through a magnified short position in ASX SPI 200 futures. For example, if both the BEAR and BBOZ Fund had $100 million in funds under management (FUM), the former would aim to maintain a short exposure to the market through SPI futures equal to around $90-110 million, whereas the latter would maintain short exposure equal to between $200-275 million.  Note the majority of FUM is invested in cash and cash equivalents on a continuous basis, with mark-to-market adjustments in each Fund’s net asset value according to changes in SPI future prices over time.

3. Duration refers to the term over which regular interest payments are due to be paid before principal is eventually repaid. Due to this longer time period of interest payments, the market value of long duration bonds is more sensitive to changes in market interest rates over time and hence tends to have a greater negative return correlation with the equity market.  Due to this price sensitivity, long duration bonds also tend to offer investors higher interest returns over time than short duration bonds.    

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