Hedged Equity
What Is a Hedge?
In simple terms, a hedge is an investment that is made with the intention of reducing the risk of a large and adverse price movement in an asset.
Hedging is similar to taking out an insurance policy. And like insurance, there is a cost to hedging. While it reduces potential risk, it also reduces potential gains, since the hedge is usually taken in the opposite direction as the asset being protected.
In the investment world, the most common way to hedge is through derivatives. These are securities that move in correspondence to one or more underlying assets. Derivatives can include options, swaps, futures and forward contracts.
There are many kinds of options and futures contracts that investors are able to hedge against almost any investment, including stocks, fixed income, interest rates, currencies, commodities, and more.
The effectiveness of a derivative hedge is expressed in terms of delta or “hedge ratio.” Delta is the amount the price of a derivative moves per $1 movement in the price of the underlying asset.
The specific hedging strategy, as well as the pricing of hedging instruments, likely depends on the downside risk of the underlying security against which the investor would like to hedge. Generally, the greater the downside risk, the greater the cost of the hedge. Downside risk tends to increase with higher levels of volatility and over time.
For example, if you want to hedge your position in a highly-volatile tech stock, an option which expires after a longer time period and which is linked to this stock will be more expensive than say a short-term option on a consumer staple stock.
Note that funds designed for downside protection do not necessarily increase the likelihood of positive returns during market downturns.
Why Is Hedging Important?
Used wisely, hedging your portfolio can become part of your long-term investment strategy. Hedges can be applied and removed as needed, without disturbing your core strategy or long-term goals.
Most importantly, hedging can help provide short-term shelter from adverse market events. This provides you with an alternative to selling in a down market, being forced to take an investment loss and perhaps incurring redemption fees, transaction costs and tax consequences.
In essence, hedging is recognizing the dangers that come with every investment and choosing to be protected from any untoward event that can impact one’s finances.
As stated previously, hedging strategies have unique risks, costs and consequences of their own (management fees, taxable events, etc.). It is important that you fully understand the strategy you plan to use and read the prospectuses for any investments you intend to use as a hedge.
Examples of Hedging Strategies
There are several common hedging strategies investors use to help mitigate portfolio risk: short selling, buying put options, selling futures contracts (often on a stock index like the S&P 500), trading volatility, and using inverse ETFs.
Inverse ETFs rise in price when the market goes down. Retail investors often use these ETFs because they are less burdensome than the other hedging strategies. No margin, options or futures is needed to buy an inverse ETF.
Another common strategy involves the use of options. An option is an agreement that lets the investor buy or sell a stock at an agreed price (called the strike price) within a specific period of time.
Let’s say you own a stock. If you purchase a put option, and the stock falls in price, the put option will go up in price – offsetting at least some of the loss in the stock price.
How to Participate in Hedging Strategies
You’re already using hedges in your everyday life. The aforementioned insurance policies you buy are a hedge against future scenarios. While hedging will not prevent an incident from occurring, it can protect you if something bad happens.
So it makes sense to do the same in your financial life.
There are several ETFs and mutual funds that use hedging strategies that are designed to reduce risk. A simple search on Magnifi indicates numerous ways for investors to access these funds with low fees.
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The information and data are as of the November 18, 2021 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.
Sustainability
What Is Sustainable Investing?
Sustainability – a company’s ability to create positive environmental and societal impact – is rapidly reshaping the corporate landscape. It is reshaping whole industries and generating new waves of growth.
The staggering scale of the disruption (and opportunities) that will play out over the next few decades are why many company executives right now are strategizing as to how to position their companies for the future in the face of ongoing megatrends, such as climate change.
More and more governments, as well as corporations, are pledging to back a United Nations campaign aiming for net-zero greenhouse gas emissions. This will affect how nearly every company operates.
Just the push to limit global temperature increases to under 2°C—the number one sustainability challenge of our time—will drive a massive transformation of the global economy. It will require investments totaling an estimated $100 trillion to $150 trillion by 2050.
Tomorrow’s best companies will be those that can operate outside of their comfort zone. Why? At its core, sustainability has a lot to do with resiliency.
Companies must build the capacity to adapt and innovate amid worldwide disruptions. In effect, sustainability requires “unlearning” how industrial society has operated for 150 years, and charting a new route to reach the same goal of delivering shareholder value.
Going forward, C-suite executives and boards must treat social responsibility and environmental stewardship not as separate functions largely disconnected from strategy, but rather as integral to corporate and business strategy.
Differences Between Sustainable Investing, Socially Responsible Investing, & ESG Investing
Sustainable Investing, Socially Responsible Investing (SRI), and ESG Investing are often used interchangeably. However, these investment approaches are each different.
Sustainability has become a catch-all term for a company’s efforts to “do better” or “do good.” This investment approach has three basic pillars: economic growth, environmental protection, and social progress. At times, this is referred to as “people, planet, and profits.” In a nutshell, sustainable investing directs capital to companies fighting climate risk and environmental destruction, while also promoting corporate responsibility.
In general, SRI investors encourage corporate practices that are morally grounded and promote environmental stewardship, consumer protection, human rights, and racial/gender diversity. Essentially, for socially responsible investors, morality trumps the bottom line.
ESG investing also focuses on three pillars. Environmental issues, which can include pollution, climate change, extreme weather, carbon management, and use of scarce resources. Social issues, which can include product safety, human rights, worker safety, customer data protection, and diversity and inclusion. Governance issues, which can include factors such as accounting standards compliance, anti-competitive behavior, and a strong ESG management process.
ESG data and metrics are used to gain insights into the success and value of a company’s performance and policies in order to mitigate risk and identify superior risk-adjusted returns. Essentially, the focus of ESG investing is on increasing the bottom line through investments in responsible companies that are being well managed.
Why Choose Sustainable Investing?
This type of investing has become Wall Street’s hottest growth area.
According to data supplied by The Forum for Sustainable and Responsible Investing, there are nearly $13 trillion invested into some form of socially responsible investing. And according to research conducted by Morgan Stanley in 2019, 85% of individual investors and 95% of millennial investors are interested in sustainable investing.
Sustainable investing makes a lot of sense, even if your only concern is the return on the money you are investing.
Like the tortoise in the fabled race with the hare, long-term investors are seeing growing evidence that this type of investing can beat traditional methods. For example, in the past few years, companies with higher ESG ratings had higher average return on invested capital, compared to companies with lower ratings, according to MSCI.
The reason for this outperformance is straightforward and obvious… ESG pushes companies to look beyond the next quarter or even the next three- to five-year business cycle in evaluating risk.
Even the results from the tough first half of 2020 were good. Morningstar said, “an impressive 72% of sustainable equity funds rank in the top halves of their Morningstar categories and all 26 ESG (environmental, social, and governance) index funds have outperformed their conventional index-fund counterparts.”
How to Participate in Sustainable Investing
With the large number of companies touting their sustainability credentials, you would need a ‘scorecard’ to keep track. A much easier route would be to purchase ETFs or mutual funds that invest in companies with specific sustainability goals. A simple search on Magnifi indicates numerous ways for investors to access sustainable funds with low fees.
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Magnifi is changing the way we shop for investments, with the world’s first semantic search engine for finance that helps users discover, compare and buy investment products such as ETFs, mutual funds and stocks. Open a Magnifi investment account today.
The information and data are as of the November 8, 2021 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.
Inflation
Inflation measures how much more expensive a set of goods and services has become over a certain period of time. In effect, inflation is the decline in purchasing power of a given currency (such as the U.S. dollar). Inflation is a major concern for investors because of the effects it may have on their investments.
Currently, most central banks – including the U.S. Federal Reserve – consider a 2% inflation to be “healthy”. Anything significantly above or below that level can have an adverse effect on the economy. Very high rates of inflation mean that unless income increases at the same rate, people are worse off, and this can lead to lower levels of consumer spending and a fall in sales for businesses. Very low inflation usually signals demand for goods and services is beneath where it should be, and this tends to slow economic growth and depress wages.
Inflation and Your Investments
Inflation can distort purchasing power over time for recipients and payers of fixed interest rates. For example, take a pensioner who receives a fixed 3% yearly increase to their pension. If inflation is higher than 3%, a pensioner’s purchasing power falls.
If inflation rises 3% every year, a retiree who has enough saved today to spend $50,000 a year would need just over $67,000 a year in 10 years and more than $90,000 per year in 20 years to fund the exact same lifestyle
On the other hand, a borrower who pays a fixed-rate mortgage of 3% would benefit from 3% inflation, because the real interest rate (the nominal rate minus the inflation rate) would be zero. And servicing this debt would be even easier if inflation were higher, as long as the borrower’s income keeps up with inflation. The lender’s real income, of course, suffers. To the extent that inflation is not factored into nominal interest rates, it creates winners and losers when it comes to purchasing power.
How to Protect Your Portfolio in Times of High Inflation
There are certain investments that are more inflation-tolerant than others or rise together with inflation. Having a well-diversified portfolio can help enhance investment returns and reduce risk during times of high inflation. Diversification is a risk management strategy in which investors spread their investments across asset classes.
Stocks
The stock market’s average annual gain of 10% has outpaced inflation over the long run. However, historically, when inflation spikes (defined as when the CPI suffers one-month increases of 0.5% or more for at least three months in a row) it has been a major headwind for stocks. In five of the previous seven such spikes since 1973, the S&P 500 index declined, suffering a median drop of 7.8%.
The ideal stocks to own in an inflationary environment are companies that can pass along higher costs to their customers because of strong demand for their products. An example of this are consumer staples stocks because they offer “necessities” like food to consumers. Also, companies that have a habit of raising their dividends regularly may allow you to outpace inflation.
Diversify Internationally
Buying international stocks can help to hedge your portfolio against a weaker US dollar. That’s because there are many major economies around the world that do not fluctuate in tandem with the US markets. In addition, rising inflation in the US can actually be advantageous for American investors in international companies whose foreign-currency profits get converted into US dollars.
Real Assets
Real assets are physical assets that have an inherent value due to their physical attributes. Real assets help diversify investment portfolios as they have a relatively low correlation with financial assets, such as stocks and bonds. Examples of real assets are real estate and commodities.
Property prices and rents charged by landlords typically go up during inflationary periods, making real estate a popular investment if you want to outrun inflation. Over the past 30 years, an index of U.S. real estate investment trusts (REITs) posted larger gains than the S&P 500 in five of the six years when inflation was 3% or higher.
Also, commodities, such as precious metals, often prosper in inflationary times as well. That’s because as the price of goods and services rise, so too does the price of the commodities used to produce those goods and services.
TIPS
Investing in bonds may seem a counterintuitive way to beat inflation. However, investors can purchase inflation-indexed bonds. In the United States, Treasury Inflation-Protected Securities (TIPS) are a popular option because it is pegged to the government’s Consumer Price Index.
When the Consumer Price Index (CPI) rises, so does the value of a TIPS investment. Not only does the base value increase but, since the interest paid is based on the base value, the amount of the interest payments rises with the base value increase. TIPS can be accessed in a variety of ways. Direct investment can be made through the U.S. Treasury or via a brokerage account. TIPS are also held in some exchange-traded funds (ETFs) and mutual funds.
Investors can gain exposure to domestic and international stocks, REITs, commodities, and TIPS through ETFs and mutual funds. A simple search on Magnifi indicates numerous ways for investors to access an array of funds with low fees.
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Magnifi is changing the way we shop for investments, with the world’s first semantic search engine for finance that helps users discover, compare and buy investment products such as ETFs, mutual funds and stocks. Open a Magnifi investment account today.
The information and data are as of the October 14, 2021 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.
Value Investing
What Is Value Investing?
Value investing is a strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value. Value investors actively search for companies they think the stock market is underestimating. They believe the market overreacts to both good and bad news, resulting in stock prices that often do not correspond to a company’s long-term fundamentals.
This market overreaction offers an opportunity to profit by buying stocks at discounted prices.
Warren Buffett is probably the best-known value investor today, but there are many others, such as Jim Rogers. Rogers once said the following: “I just wait until there is money lying in the corner [ignored by Wall Street], and all I have to do is go over there and pick it up.”
Value investors hope, as seasoned market observer Jim Grant said, “…have people agree with you… later.”
Value investors use a number of various metrics to try to find the intrinsic value of a stock. Intrinsic value is a combination of using financial analysis such as studying a company’s financial performance, revenue, earnings, cash flow, and profit as well as fundamental factors, including the company’s brand, business model, target market, and competitive advantage.
Some metrics used to value a company’s stock include: price-to-earnings, ratio, price-to-book ratio and free cash flow.
The Difference Between Value and Growth Investing
Value investing involves searching for stocks trading below their actual value. Quite often, these involve mature ex-growth industries, such as utilities and banks, as well as cyclical industries such as banking, energy and mining stocks.
Growth investing is all about finding companies that show above-average revenue and earnings growth potential, such as technology stocks.
In effect, growth investors are looking for a company at $100 a share and that will go to $200, relatively quickly. Meanwhile, value investors are looking for a company trading at $50 a share that will go to $100 within a few years as the market recognizes its true worth.
Growth investors, unlike value investors, have little interest in current income from their portfolio. Also, growth investors do not mind highly volatile stock prices because they do not need the money until well into the future.
These two investing strategies have waxed and waned in popularity historically.
In 1997, Nobel laureate Eugene Fama pointed out that value stocks had beaten growth stocks over the long term. This “discovery” was followed by the bursting of the tech bubble in 2000, and value stock prices outperformed growth by 16% over the next five years.
However, by 2005 value stocks became overpriced. And as an issue of the Journal of Banking and Finance pointed out – value investing stopped ‘working’ in most developed markets in the last 15 years.
In simple terms, when the markets are greedy, growth investors win and when they are fearful, value investors win.
Why Choose Value Investing?
For long-term investors, it is this very waxing and waning that means value stocks should be part of your portfolio.
Data from 1927 through 2020 showed that small value stocks had a return of 14.3% annually, and large value stocks had a return of 11.8% annually. During the same period, large growth stocks had a return of 10%, and small growth stocks had a return of 9.3%.
From 1927 through 2019, according to the data compiled by Nobel Prize laureate Eugene Fama and Dartmouth professor Kenneth French – over rolling 15-year time periods – value stocks have outperformed growth stocks 93% of the time. However, when looking at year-by-year performance, value outperformed growth just 62% of the time.
Currently, in a rising interest rate and inflationary environment and with growth stocks outperforming in the decade from 2010 to 2020 – value stocks are poised for a period of outperformance over growth again.
The old debate of growth investing vs. value investing will go on and on. However, history tells us that value stocks outperform over time, even if growth stocks steal the daily headlines.
So if you’re buying individual stocks, stick to fundamental investing principles of Warren Buffett. Or consider buying a broad-based value index fund that takes a lot of the risk out of stocks over the long term. A simple search on Magnifi indicates numerous ways for investors to access value funds with low fees.
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with a Magnifi Account
Magnifi is changing the way we shop for investments, with the world’s first semantic search engine for finance that helps users discover, compare and buy investment products such as ETFs, mutual funds and stocks. Open a Magnifi investment account today.
The information and data are as of the November 8, 2021 (publish date) unless otherwise noted and subject to change. This blog is sponsored by Magnifi.