After a strong surge off the market’s March 23rd low, volatility returned to the markets last week. While the increase in volatility was expected, it did trigger our dynamic hedging strategy for the second time this year. To answer the questions that have been asked about dynamic hedging, I have updated a blog posted a few years back.
A central doctrine of financial advice is to determine long-term goals, pick an asset allocation strategy to meet those goals, and stick with it. This approach is defined by strategic asset allocation and calls for setting target allocations, then periodically rebalancing the portfolio back to those targets as investment returns cause a drift from the original allocation percentages. The strategy is often referred to as “buy and hold,” rather than an active trading approach. Of course, the targets may change over time as the goals and needs change, and as the time horizon for major events (e.g. retirement and college funding) grows shorter. Practitioners of this strategy believe that trading in and out of positions in response to daily market gyrations increases costs, reduces returns, and is almost guaranteed to undermine an investor’s long-term objectives.
Market timing, on the other hand, is moving in an out of asset classes in an attempt to profit from the future direction of the market. In a truly efficient market, profiting from these trades would not be possible; however, many investors do not accept this hypothesis and believe that inefficiencies in the market persist and can be exploited. Although numerous academics believe it is impossible to time the market, most active traders believe strongly in market timing. What we know for certain is that it is very difficult to be continuously successful at market timing over the long run.
While these two strategies represent extremes in financial theory and appear to be at odds, a combination of the two may be beneficial. During periods of heightened market risk, earmarking a portion of the portfolio to take advantage of big market moves may help lower volatility. This more active approach is often referred to as tactical asset allocation. Tactical asset allocation can be achieved either through market timing or dynamic hedging. Market timing generally involves estimating future market movements while dynamic hedging does not. It takes its cue from signals in the market, such as the CBOE Volatility Index, better known as the VIX Index.
The VIX index is the most widely watched statistic to measure market risk or volatility. It is designed to measure near-term volatility — as indicated by index option prices — in the S&P 500 Index. Historically, the VIX has moved in the opposite direction of the S&P 500 about 80% of the time. When above its normal range, the VIX indicates a high level of apprehension, and therefore could be regarded as a turning point in the market.
Because of the high negative correlation between the VIX Index and the S&P 500, we have created a dynamic hedging strategy that reduces portfolio risk when the VIX is elevated. It is based on research we conducted with a local university. The goal is to improve downside protection and add value to our long-term buy-and-hold strategy. It is not based on estimates of the market’s direction and is free of the emotional elements that make investing more complicated.
Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
Washington Trust Bank.