Stock Hedges Are Misfiring

Stock Hedges Are Misfiring

Many of the hedging strategies that worked in previous bear markets are misfiring in this one, contends an article in Bloomberg. Buying the dip, taking refuge in megacaps, betting on a Fed pivot, and purchasing crash insurance are all things that have been winning approaches in previous equity bear markets—such as in 2020—and are now failing.

Indeed, after the S&P 500 fell 2.5% following Fed Chair Jerome Powell’s hawkish statement, the Cboe Volatility Index (the VIX) was essentially flat, meaning investors who bet on increased volatility didn’t have success. And the Cboe S&P 500 5% Put Protection Index, which follows a strategy that uses a month 5% “out-of-the-money puts as a hedge” while holding “a long position on the equity gauge” fell 20%, as opposed to the 2.2% it returned in March 2020. The lack of certainty with hedge strategies that have outperformed in the past is causing immense frustration on Wall Street, according to the article. And unlike in 2020, this year’s market has been jarred by rallies that go against the trend, elongating the pain into the second-slowest bear market since the 1980s. That slow-motion selloff, combined with the rapidity in which the market changed from a high-flying bull market at the beginning of the year to the current bear, is one reason why so many hedge strategies are failing to work now.

But many ETFs that utilize some of these losing hedges are still seeing inflows this year; the Simplify U.S. Equity PLUS Downside Convexity ETF, which has passive exposure to the S&P 500 and is down 25% so far this year, has had inflows of $30 million. Paul Kim of Simplify Asset Management told Bloomberg that the ETF is “working as intended because we haven’t seen the follow-through and sharp selloff the strategy is designed to protect against.” And rapid reversals have been a hallmark of this market; the 10-month bear in the S&P 500 has also had 7 rallies of at least 5% and erased 1% of intraday gains or losses at least 26 times during those months. Even with all that volatility, indexes like the VIX have been relatively muted, and that could be because investors did actually predict inflation trouble was brewing at the end of last year. Amidst those concerns, money managers had the forethought to slash equity exposure, the article explains.

And because everyone was prepared for dizzying crash, and got a slow, downward spiral instead, many of the protective options that would’ve worked in a steeper crash have failed. That shift can be seen in the sensitivity of the implied volatility gauge in connection with the motion of underlining shares. Such a gauge surged at the end of last year, and is now at its lowest point in the last 10 years. That indicates that the options once relied on during fast-changing markets aren’t working during this equity rout. And those who tried to repeat past successes didn’t do well, Benn Eifert of QVR Advisors told Bloomberg, adding, “You look at the last really big bad thing and think it could happen. And usually the last bad thing that happened isn’t going to be that much like the next bad thing to happen.” 


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