Hedging stock risk can hedge your business, too

A bear market increases the odds not only of portfolio loss, but loss of clients

Oct 16, 2017 @ 1:57 pm

By John Waggoner

Advisers who don't hedge against a bear market should remember that they could be more at risk from the stock market than their clients, according to a white paper by Meb Faber, chief investment officer of Cambria Investment Management.

As much as clients fear a bear market, advisers should, too. A bear market increases the odds not only of personal loss, but loss of clients. (And if you work for a larger employer, keep in mind that financial services firms have a tendency to put employees out on the street during market downturns.)

The paper argues that the market is long overdue for a correction, and that a permanent put option strategy is best for clients and advisers.

The warning signs:

Bull markets don't die of old age, but they don't live forever, either. The current bull market started March 9, 2009, and is now 78% longer than the average bull market.

Stocks aren't cheap. Warren Buffett's favorite measure of stock valuation is comparing the value of the stock market to U.S. gross domestic product. It's now about 30% more expensive than GDP — not as hugely overvalued as it was in 2000, but higher than it was in 2007. The Shiller 10-year cyclically adjusted PE ratio shows similar overvaluation.

Investors are awfully cheerful, according to sentiment indicators. That's not usually the time to buy stocks. And the market has shown less volatility than a brick.

All of which doesn't necessarily mean a bear market is around the corner.

"We all know markets can keep climbing far past the point logic would suggest otherwise," Mr. Faber wrote.

Traditional defensive strategies include diversification among asset classes and international markets, but, with the exception of cash, they have spotty records against bear markets, Mr. Faber said. Buying out-of-the-money puts on a U.S. stock portfolio provides good bear market protection.

But insurance isn't free, and those put options won't help a portfolio in a bull market. And that means that over the past 30 years, adding puts to a portfolio hasn't beaten the S&P 500. So why bother?

Everyone, in theory, is a long-term, buy-and-hold investor — at least until there are big, scary downturns. A hedging strategy can reduce those, as well as the risk that a client will demand to get out of the market at the wrong time.

"Lower drawdowns are much easier to stomach, and in a real-world setting, would do a vastly better job at preventing panic-selling. Given this perspective shift, I would argue the permanent hedge does help — significantly — despite the costs involved," Mr. Faber wrote. "That's because it's more likely to keep your money invested, working for you."

And, he said, it's more likely to keep you working.

"For advisers, [a falling stock market] impacts their personal portfolio, their shorter-term business income, potentially their longer-term business income, and in dire situations, the viability of their company," he wrote. "Many investors can reduce their equity exposure, but many advisers and investment companies cannot."


What do you think?

View comments

Recommended for you

Featured video


The bizarro world of DOL and SEC rule supporters

Managing editor Christina Nelson talks with senior reporter Mark Schoeff Jr. about why groups that supported the Labor Department's fiduciary rule oppose much of the SEC advice package, and vice versa.

Latest news & opinion

10 countries where your clients should consider retiring

These countries offer the greatest security for their retirees, according to the 2018 Natixis Global Retirement Index.

10 most affordable U.S. cities for renters

Here are the U.S. cities that are most affordable for renters, according to Business Student.com, which compared the cost of rent to average salaries.

9 best - new - financial adviser jokes

Scroll through for nine new financial adviser laughs.

Captrust, prominent 401(k) advice firm, ramps up its wealth management business

Captrust wants to grow annual revenue from wealth management to 50% from 30% over the next five years.

Fidelity CEO says zero-fee funds aimed at expanding its universe

Johnson says way to prosper in financial services is 'by building relationships.'


Hi! Glad you're here and we hope you like all the great work we do here at InvestmentNews. But what we do is expensive and is funded in part by our sponsors. So won't you show our sponsors a little love by whitelisting investmentnews.com? It'll help us continue to serve you.

Yes, show me how to whitelist investmentnews.com

Ad blocker detected. Please whitelist us or give premium a try.


Subscribe and Save 60%

Premium Access
Print + Digital

Learn more
Subscribe to Print