Hedging, Part 2

Nov 07, 2016 | by Franck Cushner, CFP®

To pick up where we left off last week, one of the benefits of studying relationships on an asset-to-asset approach is it gives you an executable hedge. While we ended on recent Peso and S&P correlation, we can now step back to discuss two historic common hedges: Oil prices with the US Dollar and Treasuries with the S&P. The key concept with hedging is that fundamental characteristics compel one asset to offset fluctuations in the other asset’s price.  When the relationship holds, you, the investor, are provided improved downside protection (and, unfortunately, limited upside).

Why are oil and the dollar connected?

All Oil is priced in the US Dollar. If a barrel of Oil is $55 and the exporting country has an exchange rate of 1.05 to the Dollar, were the Dollar to increase in value to 1.10, if the price of Oil has no other factors influence value, the price would theoretically adjust immediately to $52.50 (to be worth the same amount in the foreign currency).  Further, with a large downturn in Oil prices, many of the exporting countries’ currencies may also lose value (strengthening the Dollar). To clarify, central banks of oil exporting countries may be potentially incentivized to devalue their currency in order to offer a cheaper, more competitive product (or they could instead cut production, which fits the ‘design’ of the OPEC cartel).

And how long does this last?

One of the difficulties of hedging is that effectiveness changes over time. There is more than oil influencing exchange rates and vice versa. For example, using an Oil and Dollar ETF as a proxy (USO and UUP), the 60-day correlation has been negative 86% of the Oil downturn period (August 2014 to today). However, this has not, likely, been solely related to the historical relationship.  It would not be prudent to ignore the impacts of increasing US Oil supply and volatile currency events such as Swiss Franc unpegging, Brexit, and Greek default, and the implications which opposite events pose. For all assets, correlations are not static. It is the responsibility of yourself (or your portfolio manager) to ensure that current hedges being utilized are statistically and fundamentally sound.

What about Treasuries and the S&P?

When the levels of uncertainty increase in the Equity markets, people tend towards risk-off trades.  US Treasuries are currently and historically the global risk-free asset, as they have always paid investors 100 pennies to the Dollar. The yield you are quoted is the payoff you will receive, as long as you hold till maturity. If you don’t want to put down the capital required for purchasing Treasuries, you can mimic a long Treasury position by owning a long-term Treasury ETF such as TLT. For your equity market position, you’d likely own the most popular S&P 500 ETF, SPY. Looking at daily changes in price from March 2005 to last Friday, a 60 day rolling correlation between SPY and TLT has been negative 87% of the time.  This fits our basic hypothesis, that as SPY performs poorly, investors, more often than not, migrate towards TLT – meaning as the S&P performs poorly, people invest in Treasuries, TLT’s underlying. Now, this doesn’t require that these are the same investors per se (as some will leave the market altogether), just that when we see a decrease in the S&P, 87% of the time we also see an increase in Treasuries (as reflected in SPY and TLT).

So overall, these concepts work?

Yes, the concepts tend to work in most environments to varying degrees in execution. As stated earlier, correlations fluctuate over time. Many relationships will appear much stronger than common sense suggests, some will vanish altogether, and others may be primarily spurious. You can try to measure how effective a hedge may serve by reviewing longer-term historical data and current headlines. Overall, trust that you are wrong. Focusing more on disproving what you “know” and proving what you don’t believe can help you find where personal bias is misleading and alleviate the flaws of over confidence. Be excited to be wrong, it just may give you an edge.

**This is not a recommendation of a trade nor investment. Rather using real tickers so you can do your own research.
***Note, this blog was updated on November 8 for sake of clarity, so not the original post.

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