Hedging hurts more than stock market declines, study says

Common sense (or desperation) makes hedging strategies the answer to times of stock market crashes. Thus, when major index stocks are in trouble, a series of capital protection measures are adopted. On the face of it , this is a healthy measure to prevent the loss of investors’ capital in the face of complex times.

However, not everyone agrees on the effectiveness of strategies to protect against market crashes. A recent article by NVDR experts Roni Israelov and David Nze Ndong claims that hedges often cause major headaches. In other words, they make the problems they are supposed to solve worse, and there is every reason for that to be the case, the experts say.

There are countless alternatives for managing risk in times of volatility. Within the category of hedging, strategies abound and that is precisely what the aforementioned specialists are referring to. Each strategy focuses on a different collapse situation and the problem arises when a protection measure is applied that does not coincide with a given withdrawal. The latter, they explain, is what happens in most cases.

The unpredictability of stock market crashes

Along with the dollar, uncertainty is the currency of course for the New York Stock Exchange. Both stock market declines and the development and durability of those reversals are a sea in which few know how to navigate. Consequently, knowing the nature of these crashes is essential to implement a protection or hedging strategy. From NVDR’s point of view, this is a problem that makes the various hedging measures highly inefficient.

What could be seen as a prudent move on the part of investors would end up causing greater capital losses than the crisis itself. This statement comes at a time when the stock market’s trajectory is uncertain and speculation abounds. As the Federal Reserve announces stormy weather, investors are considering moving their capital out of risky stocks and into defensive sectors.

The problem Israelov envisions lies there. “Different hedging strategies protect against different types of crashes – and who knows what the next crash will look like?” questions the CFO of the aforementioned financial services firm. Then he goes a bit further:

“Is it a catastrophic 30% drop in one week or 30-50% over a whole year? How that plunge occurs determines which strategy will or will not be effective.”

The article sees the last three years of declines and unusual situations in the stock market as an excellent precedent for the future. They see the current situation as a laboratory in which to analyze various strategies in times of rapidly changing conditions.

The failure of hedging strategies in recent stock market crashes

During the last three years there were two market crashes and a period of accelerated growth. In theory, hedging strategies should have translated into two years of good performance (the 2020 and 2022 crashes). They would also be accompanied by a year of poor performance with the rise of stocks during the easy money boom. But the outcome was generally bad over the three years for those who took defensive positions.

In the article, the experts look at three popular equity tail protection strategies and note that they perform differently in each case. For example, hedging measures during the 2020 downturn, when the pandemic was announced, had dramatically different results than in the 2022 bear market. Thus, they conclude that hedging tools that succeed in one environment tend to fail in another, despite the fact that both involve downturns.

The ways to hedge against a crash are plentiful and work perfectly as long as they are applied at the right time. Experts consider that this is the case where theory presents an ideal situation that is difficult to put into practice. In that sense, applying the right strategy for a given downturn is no easier than timing the market, they stress.

That suggests that throwing darts at a dartboard while blindfolded might be an apt comparison when it comes to employing a strategy during stock market crashes. In previous research, these experts believe it is safest to protect capital by turning to cash.

The three strategies evaluated in the article

As mentioned, the analysts took three of the most popular strategies to validate their points. It is worth mentioning that they are applied on a monthly basis and employ products in which direct sales contracts are included. In addition, they are accompanied by options in various combinations and index futures. As you might expect, these strategies face problems when stocks go up and when they go down they work well, or they should.

In the latter part, i.e., when they were expected to work, is when they failed. These are the three strategies:

The result in all three cases is a form of cushion against eventual stock market declines. Theory and history say that many investors have weathered severe headwinds with these and other hedging strategies. However, conditions in recent years were unorthodox and many investors failed to read what was coming.

In any case, the strategies should have paid off well in 2020 and the agonizing 2022, but the situation was different, the paper concludes.

The results of the three strategies studied

In March 2020, the World Health Organization officially announced the arrival of a new pandemic caused by covid-19. Immediately, panic gripped the markets and the fall of stocks was rapid and violent. The announcement of the pandemic was an open secret and investors already had their capital protected with one of the strategies mentioned above.

And they were not wrong, the results of these strategies were as everyone expected. Shortly after the easy money bubble of late 2020 and 2021, tapering and tight monetary policy announcements began. In 2022, the Fed started rate hikes and the rest is history, the market started to collapse in a slow, but unchecked manner throughout the year. In that scenario, the same protective strategies backfired.

These were the results of the three strategies:

• In the first case, hedging was excellent during the 2020 plunge and went on to cut losses in the S&P 500 by 3/4. But the characteristics of the 2022 crash led holders of the strategy to experience losses greater than they would have suffered just owning the S&P.
• In the second case, the hedge was also optimal during the 2020 downturn. Such were the returns, that the gains erased the previous 5 years of losses caused by the market’s uptrends. But in 2022, the strategy crashed miserably despite massive stock sales. The stock market crashes of 2020 and 2022, by their outcomes, made it clear that the long volatility strategy was a useless element.
• In the third case, things went a little better. However, there is talk of gains in the 2020 drop of 12% and just 1% in the 2022 dosed crash.

The other side of the issue

But another point made by specialists is that these are just three of many strategies. With so many options to choose from, it is more likely that you will not pick the most appropriate one for a given bear market situation.

“What I’m trying to say is that there are hedges of all flavors. I only covered three, and the dispersion in results when a crash occurs can be shocking,” the article summarizes. Similarly, the experts insist:

“Since each hedging strategy is designed to hedge against a different type of crash, that makes it difficult to determine which is the best hedging strategy to implement.”

The experts conclude that there are ways to flesh out a solution to this problem. At that stage, they say many investors take a “pooled approach” to create a shield against stock market declines. This involves diversifying hedges to increase the chances that at least one of them will be the right choice.