With economic outlooks shifting for 2020 with some saying recession, and others expecting continued growth, investors may be coming back to the question of how to position portfolios given uncertainty. To help guide portfolio decision making, forecasting expected returns for the market depends on a belief that either this record-setting 10-year bull market will continue, or that we may see a change in markets over the next year. To illustrate the importance of changing up the bet, we have a few simple questions that can illuminate a path.
Two questions to ask investors are: based on your belief, what are the odds that the market will go up by 10% or more over the next 12 months? And alternatively, what are the odds that the market will go down by 10% or more over the next 12 months? Using answers to both, we can assign a probability to return expectations for the next year.
Hypothetically, let’s assume an investor who is invested in an unhedged equity strategy believes there is a 60% probability that the market will go up by 10% or more over the next 12 months, and a 40% chance the market will go down 10% or more. In aggregate, that set of beliefs would equate to a 2% outlook for the next 12 months for that investment. (see Figure 1)
Figure 1
Hypothetical Return for Unhedged Equity Strategy | Market Probability | Expected Return |
Investors believe that there’s a 60% chance that market will go up 10% or more |
60% x 10% = | 6% |
Investors believe that there’s a 40% chance that market will go down 10% or more |
40% x -10% = | -4% |
6% + -4% = 2% | ||
Total Expected Return of Unhedged Equity | 2% |
Now, what if you look at that same market scenario (i.e., 60% chance that the market will go up and 40% chance the market will go down) through the lens of a hedged equity strategy that targets a 60% upside capture and 40% downside capture?
In this case, it could equate to a 3.6% return possibility on the upside, and -1.6% return possibility on the downside—or a 2% total return outlook for the investment (see Figure 2)
Figure 2
Hypothetical Return for Hedged Equity Strategy | Expected Return x Upside/Downside | |
Expected Return for Strategy capturing 60% of Upside | 6% x 60% = | 3.6% |
Expected Return for Strategy capturing 40% Downside | -4% x 40% = | -1.6% |
3.6% + -1.6% = 2% | ||
Total Expected Return of Hedged Equity (with 60% Upside/40% Downside Capture) | 2% |
In comparing the two investment examples, you can see that (in the upside scenario) the total expected return of the hedged equity example matched the unhedged equity example (i.e., 2%) but with less risk, or beta exposure.
Now what if you were less optimistic about the market and flipped your projections around by assigning a 40% probability that the market will go up by 10%, and a 60% chance the market will go down? (see Figures 3 and 4)
Figure 3
Hypothetical Return for Unhedged Equity Strategy | Market Probability | Expected Return |
Investors believes that there’s a 40% chance that market will go up 10% | 40% x 10% = | 4% |
Investors believes that there’s a 40% chance that market will go down 10% | 60% x -10% = | -6% |
4% + -6% = -2% | ||
Total Expected Return of Unhedged Equity | -2% |
Figure 4
Hypothetical Return for Hedged Equity Strategy (with 60% Upside/40% Downside Capture) |
Expected Return x Upside/Downside | |
Expected Return for Strategy capturing 60% of Upside | 4% x 60% = | 2.4% |
Expected Return for Strategy capturing 40% Downside | -6% x 40% = | -2.4% |
2.4% + -2.4% = 0% | ||
Total Expected Return of Hedged Equity | 0% |
In this scenario, you see that the unhedged equity returned -2% vs. the hedged equity strategy which was flat (0%)—a savings of 2%.
Finally, let’s consider if your forecast has a left tail. For example, assume the same probability of an up or down market as our first scenario (60% chance of going up, 40% chance of going down) except that on the downside it would be a more significant drop (i.e., 20%) while the upside gain remains the same (i.e., 10%). (see Figures 5 and 6)
Figure 5
Hypothetical Return for Unhedged Equity Strategy | Market Probability | Expected Return |
Investors believes that there’s a 60% chance that market will go up 10% | 60% x 10% = | 6% |
Investors believes that there’s a 40% chance that market will go down 20% | 40% x -20% = | -8% |
6% + -8% = -2% | ||
Total Expected Return of Unhedged Equity | -2% |
Figure 6
Hypothetical Return for Hedged Equity Strategy (with 60% Upside/40% Downside Capture) |
Expected Return x Upside/Downside | |
Expected Return for Strategy capturing 60% of Upside | 6% x 60% = | 3.6% |
Expected Return for Strategy capturing 40% of Downside | -8% x 40% = | -3.2% |
3.6% + -3.2% = 0.4% | ||
Total Expected Return of Hedged Equity | 0.4% |
In this situation, you’re far better off investing in the hedged equity position above (i.e., market forecast is down -2% while hedged equity forecast is up 0.4%.
Because it is difficult to know exactly which scenario will play out, consider this: protection during down markets may have a bigger impact than capturing 100% of the market’s upside over time. In other words, by decreasing the magnitude of drawdowns in down markets, investors may recover more quickly when markets bounce back, potentially leaving them in a better position to compound returns.
Hedged equity strategies, such as Long/Short Equity, have a similar return profile to equities but achieve those returns while managing downside risk, allowing portfolios to be more resilient during periods of uncertainty, potentially without enormous opportunity cost. When looking at hedged equity strategies, look for those with an asymmetric upside to downside capture ratio, as they will have the greatest overall impact on portfolio outcomes. If the selected strategy captures equal amounts of the downside and upside, or worse, more of the downside than upside, then there will be no performance benefit.
To run through your own market scenarios, we created this online Forecasting Calculator >