Are Index Hedges Worth It In Today’s Frothy Market?

Index hedges are largely considered to be the cheapest and easiest way to obtain portfolio insurance for a well-diversified portfolio against adverse market movement over a period of time. Hedge funds get their name largely from the fact that typically a percentage of the fund’s portfolio is "hedged" on the downside, protecting the portfolio and, in theory, providing better returns in good times and in bad to investors who have trusted the given hedge fund with their money.

Of late, iconic investors in large institutional names such as Prem Watsa of Fairfax Financial Holdings Ltd. (TSX: FFH) have reduced their index hedges due to the perception that the bull market has legs and will continue to run for some time. In fact, in the case of Fairfax, Prem Watsa announced this year in a letter to shareholders that the fund was moving from a position of being 115% hedged as of February 2016 (that means more downside protection than the entire value of the portfolio), to a position of no hedges.

While the bulls appear to be running strong with respect to financial markets and continued optimism that a Trump presidency in the U.S. will provide more fuel for equities moving forward, many analysts have continued to warn of overheating with respect to global equities markets due to pervasively low interest rates for some time supporting price increases which may not be sustainable.

Taking a more cautious approach has always been my mantra, however timing such a decline may be difficult. As a very wise man once told me "insurance is often much cheaper to buy before the water levels increase." I’m taking that advice right now.