Cost of Hedging

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

Just a note - Morningstar has introduced a new "long-short" category of funds, into which the Strategic Growth Fund has been placed. As most of our shareholders know, the Strategic Growth Fund isn't intended to track the major indices, and its investment position varies with market conditions. In addition to allowing hedged positions, it has the flexibility to take unhedged investment positions, or even to add leverage by placing a small percentage of assets into call options (which I would expect to be appropriate in periods when both valuations and market action are favorable). So while the Fund's strategy makes it difficult to compare with "plain vanilla" long-only funds over short periods or portions of the market cycle, it is emphatically a risk-managed growth fund intended for long-term equity investors with an investment horizon that includes at least a full market cycle (i.e. bull markets and bear markets combined). It is not a permanently hedged fund nor exactly a "long-short" fund either (which is commonly understood to be a fund that takes both long and short positions in individual stocks). The fact that my only personal investments are in the two Hussman Funds (outside of a small amount in money market funds) underscores my view of them as core holdings, though I am pleased that many shareholders have also chosen the Funds as "diversifiers." I think the effort by Morningstar to properly categorize hedge-capable funds is commendable, though my preference would be for Morningstar to rename the category something along the lines of "Alternative Strategy." Meanwhile, the move to a new category has no bearing on our investment practices, which remain unchanged.

Also, a nod to Google's CFO George Reyes for the willingness to state a clear fact, and even going so far as to identify it as obvious: "Clearly, our growth rates are slowing and you can see that each and every quarter... We're getting to the point where the law of large numbers starts to take root." While I'm no fan of Google's valuation, the company should count an honest CFO as a major asset. Meanwhile, many of Google's shareholders (as well as at least one CNBC reporter) characterized this simple candor as a "gaffe." The desire of investors to tuck their fingers in their ears and hum, and to prefer "strong numbers" over honest ones, is what gave us Enron and Worldcom.

[Geeks Note: also, lest we forever lose a common understanding of the term, the "law of large numbers" has nothing to do with the notion that growth rates generally slow when a company becomes large enough. Rather, it is a statistical result that, given sample observations of some random variable X, the average value of the sample approaches the true population mean of X as the size of the sample becomes large. For instance, if you flip a coin enough times, the average number of heads converges toward 50%, even though no single throw is predictable].

How much does hedging "cost"?

We know that if a portfolio or a market is perfectly efficient, the only way to achieve higher expected return is to accept higher risk. Of course, even in this situation, the actual return in any specific period might be negative, but the assumption is that over a large number of periods, the law of large numbers will hold, and the investor's actual return will look fairly close to the expected return the investor bargained for (Wow, we got to use that Geeks Note almost immediately!).

There's an important assumption above that shouldn't be overlooked. Namely, we've assumed the market or portfolio was efficient - meaning that it was both appropriately diversified and appropriately priced. As it happens, when a portfolio or market isn't perfectly efficient, the relationship between risk and return is far less reliable. Some risks should be avoided, and can be avoided costlessly. In overpriced markets with relatively poor internals, for example, the acceptance of large amounts of risk has historically produced negative returns, on average. Likewise, if a portfolio is poorly diversified, it is usually possible to reduce risk considerably without reducing expected return at all.

If risk is managed correctly, it may be possible to reduce risk without giving up any expected return, when measured over the full market cycle. Reducing risk, by periodically hedging, avoiding or diversifying it away, can actually result in higher returns over the full market cycle.

I emphasize "over the full market cycle" to make the point that it is generally impossible to forecast short-term movements in the market, or even identify bull and bear markets with great precision. So hedging may very well reduce returns in certain periods or over some portion of the market cycle. It's the full cycle - the combination of bull and bear markets; the span from one bull market peak to another peak several years later - that is the most representative horizon over which long-term investors should evaluate their approaches.

It isn't useful to base an investment approach on any hope of forecasting short-term market outcomes. It is realistic to a) focus on objective market characteristics (in our case, valuations and market action) that have historically produced differing return/risk outcomes on average, b) to align one's portfolio based on those probable average outcomes, and then c) to allow time for the law of large numbers - month by month, year by year - to take hold. That is, you don't expect negative market conditions to produce a market decline this week, or this month, or even this year. You just expect them to produce unsatisfactory investment returns on average. Similarly, you don't expect favorable market conditions to produce a market advance this week, this month, or even this year. You just expect them to produce satisfactory investment returns on average.

In short, it's often assumed that the only way to reduce risk is to accept lower expected returns. Fortunately, the historical record indicates that this assumption isn't true. If we can identify market characteristics that are associated with differing return/risk profiles, it should be possible to improve on the return/risk performance of a passive buy-and-hold approach. The strategy is to accept greater risk in conditions that have typically delivered a high return/risk profile, and to accept less risk in conditions that have typically delivered a poor return/risk profile. Simple to say, but exceedingly hard to do in practice because it requires discipline.

Hedges carry implied "interest"

It's important to note that when we hedge our stock holdings against the impact of market fluctuations (using futures or options combinations), the hedges actually act as interest-bearing short sales. For example, the interest rate implicitly priced into S&P 500 futures and option combinations is presently close to 5% annually (as a rule-of-thumb, the implied rate tends to sit between the broker call rate, currently about 6.25%, and short-term Treasury bill yields, currently about 4.5%). That means that if we were to be fully hedged against market fluctuations and the major indices were, in fact, to achieve a positive annual total return of about 5%, the reduction in market risk through hedging would not produce any reduction in investment return. For more information on how options and futures hedges work, see the April 18, 2005 comment.

In general, the total return on a fully hedged investment position is: the total return on the stocks owned in the portfolio, minus the total return on the indices used to hedge, plus the short-term interest rate implied in the hedging instruments. In other words, hedging only reduces returns by the amount that the major indices outpace short-term interest rates. (If say, 70% of the portfolio is hedged, you get the total return on the stocks in the portfolio, minus 70% of the index total return, plus 70% of the interest rate).

This is important, because based on the latest record level of S&P 500 earnings, the S&P 500 currently sports a price/earnings ratio of about 18 (the historical average multiple on fresh record earnings is about 12). Even if we assume that 5 years from now, the index merely touches a multiple of 16, and we also assume that earnings continue to grow along the peak of their 6% long-term growth channel, the 5-year average total return on the S&P 500 would only be about 5.44%. The implication here is even if the market continues to deliver positive returns in the coming years, it would take only a modest normalization in valuations to make full hedging entirely costless. That is, it would be possible to entirely hedge the impact of market fluctuations without sacrificing anything in terms of total returns.

The risk, of course, is that the market could outperform short-term interest rates if valuations remain persistently high or increase further. In that case, the total return of a hedged portfolio would be the return on the stocks held in the portfolio, reduced by the difference between the market's return and the short-term interest rate. So for example, if the implied interest rate is 5% and the major indices advance by 8% annually, a full hedge against market fluctuations would clip total returns by about 3% annually.

A few figures: from the inception of the Strategic Growth Fund on July 24, 2000 through February 28, 2006, the average annual total return on the Strategic Growth Fund was 14.02%. The equity investments and cash equivalents held by the Fund have achieved average annual total returns of 11.21% after expenses. The S&P 500 has achieved average annual total returns of -0.75%, with the Russell 2000 Index achieving average annual total returns of 7.86%. Given that our hedge has typically been about 75% S&P 500 and 25% Russell, our hedging vehicles have had average annual total returns of approximately 1.40% annually. Meanwhile, the average 3-month Treasury yield has been about 2.52%.

To illustrate hedging calculations using these figures, a persistently and fully hedged position would have been expected to achieve returns of approximately 11.21% - 1.40% + 2.52% = 12.33% annually. The actual annual total return of the Strategic Growth Fund was higher because it was not, in fact, fully hedged during this entire period, but was partially unhedged during 2003, which was the strongest year for the stock market during the lifetime of the Fund.

Since about 1998, the level of short term interest rates has been quite low, but they have still exceeded the total return on the major indices, meaning that a fully hedged position would have both reduced risk and added return. Needless to say, with valuations rich once again, and implied short term interest rates close to 5%, any further increase in those rates will tend to increase the attractiveness of hedging strategies, and could place downward pressure on the major indices.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations and relatively neutral market action. Market action has provided exceedingly little information in recent weeks, neither clearing the recent overbought condition with a substantial selloff (which would provide information if market internals were to hold up well in the face of weakness in the major indices), nor displaying evidence of robust sponsorship for stocks. Excitement about the stock market has generally been confined to occasional, marginal new highs, but little progress beyond prior peaks. Since even fresh evidence of investor risk-seeking and sponsorship would probably increase our exposure to market risk only moderately, the majority of my day-to-day focus continues to be individual stock analysis rather than placing much focus on potential market direction.

In bonds, the Market Climate continues to be characterized by unfavorable valuations and moderately unfavorable market action. As Bill Hester points out in his new piece on inflation surprises, there may be some additional upward pressure on forthcoming inflation figures. The other areas of focus remain the U.S. dollar, and credit spreads. With regard to credit, I continue to monitor spreads like the difference between Moody's AAA yields and BAA yields, the difference between the yield on the Dow 20 bond average (reported in Barrons, though substantial changes should be checked over 2 weeks to rule out periodic data errors) and 10-year Treasury yields, and the difference in yield between 6-month commercial paper and 6-month Treasury bill yields, among others. At present, we don't observe much pressure on credit spreads or the U.S. dollar. I continue to believe that fresh economic weakness is likely to be heralded by abrupt dollar weakness, abrupt widening of credit spreads, or both. To the extent that we're not seeing that yet, the main short-term focus continues to be the potential for inflation surprises.

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New from Bill Hester: Inflation Data May Continue to Surprise

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Note - The latest semiannual report of the Hussman Funds contains additional information and graphs of Fund performance, as well as information on fees and expenses. As of 2/28/06, the average annual total returns for the Strategic Growth Fund are as follows: 1 year 6.29%, 3 years 11.78%, 5 years 11.63%, since inception on July 24, 2000 14.02%. Past performance is not indicative of future results and there is no assurance that the Fund will achieve its investment objectives. Please see additional disclosure information at the bottom of this report.

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic Total Return Fund, the Hussman Strategic International Fund, and the Hussman Strategic Dividend Value Fund, as well as Fund reports and other information, are available by clicking "The Funds" menu button from any page of this website.

Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).