Hedging Against Stock Market Dangers Could Make Losses Much Worse

(Bloomberg) — Stocks are unpredictable, so people buy protection in case they crash. But the tactics Wall Street has devised to protect investors at times of crisis are just as hard to forecast, and what seems like prudent hedging may just make things worse.

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That’s a finding of new research by Roni Israelov, chief investment officer of Boston-based financial services firm NDVR, who made waves with prior papers arguing that cash is usually a better equity hedge than buying put options. Now the former AQR Capital strategist is back with a point-by-point dissection of how popular volatility strategies sometimes fail users at exactly the wrong time.

The warning comes as predictions for market chaos abound. A little over a month ago, Mark Spitznagel at tail-risk hedge fund Universa Investments told clients that ballooning debts across the global economy are poised to wreak market havoc rivaling the Great Depression. Israelov’s paper says that it takes more than knowing an asset will stumble to make money buying protection on it.

“Different protection strategies protect against different types of drawdowns. And who knows what the next drawdown is going to look like?” Israelov said in an interview. Is it “a catastrophe as markets drop by 30% in a week, or they drop by 30% or 50% over the entire year? How it occurs has a huge impact on which hedging will pay off, and which will not.”

Israelov considers recent market history a good laboratory to test tail-risk tactics given how quickly things changed. The last three years included a nearly straight-down plummet as the 2020 Covid crisis struck, a lumbering bear market in 2022, and the sharp, retail-fueled meltup of late 2020 and 2021.

In the paper titled “Equity Tail Protection Strategies Before, During, and After Covid,” Israelov and colleague David Nze Ndong studied three popular hedging strategies’ performances during those regimes. Each met with success and failure, which is Israelov’s point: Hedging tools that work well in one environment tended to struggle in others.

To be sure, there are innumerable ways to hedge stocks, and many work perfectly well if deployed at the right time. Israelov’s argument is that succeeding at that is no easier than any other attempt to time the market.

Employed on a rolling monthly basis, his three hedging models use products including straight put contracts, index futures and a combination of options. Unsurprisingly all of them struggle when stocks go up. More notable is their performance during market retrenchments where they’re supposed to work as a buffer.

Take a popular trade that involves owning the S&P 500 and put options 5% below the index’s level as a way of muting the impact of stock market declines. While it worked well during the Covid crash, reducing the loss in the S&P 500 by three quarters, the slow-slog nature of the 2022 bear market saddled holders of the position with losses worse than if they’d only owned the plummeting S&P 500.

Another strategy is a long position in futures on the Cboe Volatility Index, or VIX. It was also a major winner in the Covid crash, scoring gains that effectively offset the prior five years of underperformance when equities were surging in a bull market. Yet in 2022, the VIX failed to spike even as stocks sold off. That dynamic turned long-VIX into a loser.

A third strategy uses an options cocktail known as “long volatility,” in which matched puts and calls are purchased at the S&P 500’s level and also at the same distance above and below it. While a plain-vanilla version of the trade made money during each of the last two major drawdowns, its returns spanned a wide range: up almost 12% during two-month plunge in 2020 and only 1% in 2022.

Complicating matters is the choice of whether to trade the S&P 500 itself as part of the “long volatility” strategy, as many managers do. During the Covid crash, buying stocks as the market fell, a tactic known as delta hedging, erased all the profits from options, turning an 11.7% gain into just 0.2%.

“What I’m trying to get out there is, that there are many flavors of protection. I only covered three, and the dispersion in outcomes when a drawdown happens can be material,” Israelov said by phone. “Given that every protection strategy is sort of designed to protect against a different type of drawdown, that makes it difficult to ascertain which is the best protection strategy to put in place.”

One solution that some investors resort to, according to Israelov, is an “ensemble approach” that diversifies the hedges and increases the likelihood of having at least one paying off during any type of pullback.

“Those who implement hedging solutions should plan for the possibility – as remote as it might be – that their hedges make things worse in times of stress,” he wrote in the paper. “Finding a panacea for all types of drawdowns (other than simply reducing allocations to equities) seems unlikely.”