Hedging for Different Market Scenarios

Hedging for Different Market Scenarios

A look at specific strategies, and their trade-offs, for diversifying equity risk.

More investors are considering broadening their approach to diversifying equity risk to include strategies such as long duration bonds, managed futures, alternative risk premia, and tail risk hedging. However, it’s important for investors to know in what types of environments each strategy is more likely to work and in what environments each are likely to be less effective.

What this chart shows

Not every type of risk-mitigating strategy can be expected to work in every type of market sell-off.

  • High quality sovereign bonds, such as long duration U.S. Treasuries, have historically been an effective hedge during flight-to-quality episodes, but can incur negative returns if interest rates rise faster than consensus expectations.
  • Trend-following strategies have historically performed well in trending markets and could pair well with long duration bonds (for example,  the trend-follower can reduce interest rate risk by shorting rates during a sustained sell-off in rates), but are susceptible to rapid reversals in trends.
  • Alternative risk premia strategies may enhance a trend-following/long duration bonds combination further, as they have the potential to do well in non-trending markets and can act as an uncorrelated return driver. But they can be vulnerable to parallel drawdowns in multiple risk premia, however uncommon these might be.
  • Tail risk hedging may offer a higher degree of reliability, albeit at the expense of short-term return potential. In contrast to the approaches above, tail risk hedging is based on contractual derivatives – not correlations, which can break. And contrary to conventional wisdom, tail risk hedges do not always have a negative expected return or a cost associated with them.

What it means for investors

There is no “silver bullet” strategy to hedge an investor’s portfolio from risk events. We believe that investors should “diversify their diversifiers” by identifying the ideal blend of correlation-based hedges and outright hedges for their unique circumstances.

Source: PIMCO https://www.pimco.com.au/en-au/resources/education/hedging-for-different-market-scenarios


Prepare for Economic Changes with a Broader Allocation

Prepare for Economic Changes with a Broader Allocation

Learn how a diversified portfolio can be prepared for a number of economic scenarios.

A portfolio mix that combines both traditional and non-traditional asset classes – such as TIPS and commodities – may be better positioned for a number of potential economic and inflationary scenarios.

What this chart shows

Stocks, bonds and cash, which form the core of many diversified portfolios, generally add value in some economic scenarios. In higher inflationary environments, assets such as emerging market securities, commodities and Treasury Inflation-Protected Securities (TIPS) may perform better.

What it means for investors

Rounding out a core portfolio with non-traditional and real (inflation-hedging) assets can help investors participate in a broader range of economic environments while also managing volatility, which is particularly important in uncertain economic times.


Source: PIMCO https://www.pimco.com.au/en-au/resources/education/prepare-for-economic-changes-with-a-broader-allocation

If you have questions and would like your financial situation to be evaluated, please email us on ds@bluerocke.com with your contacts, for an exploratory meeting, at our cost, not yours.

The Benefits of Staying Invested

The Benefits of Staying Invested

Investors are more likely to reach their long-term goals if they remain invested and avoid short-term decisions that may take them off course.

What this chart shows

As this hypothetical example shows, investors may make suboptimal decisions when emotions take over, tending to buy out of excitement when the market is going up and sell out of fear when the market is falling. Markets do ultimately normalize, and when they do, those who stay invested may benefit more than those who don’t.

What it means for investors

To help reason prevail, first make sure you’re comfortable with your allocation to riskier assets and that it makes sense in light of your time horizon. You also need a logical framework for financial decisions and a plan that anticipates periods of market turbulence. A systematic approach for reviewing portfolio results, with pre-established guidelines for selling, may help as well.


Source: PIMCO https://www.pimco.com.au/en-au/resources/education/the-benefits-of-staying-invested

If you have questions and would like your financial situation to be evaluated, please email us on ds@bluerocke.com with your contacts, for an exploratory meeting, at our cost, not yours.

Understanding Inflation

Understanding Inflation

Inflation affects all aspects of the economy, from consumer spending, business investment and employment rates to government programs, tax policies, and interest rates. Understanding inflation is crucial to investing because inflation can reduce the value of investment returns.

What is inflation?

Inflation is a sustained rise in overall price levels. Moderate inflation is associated with economic growth, while high inflation can signal an overheated economy.

As an economy grows, businesses and consumers spend more money on goods and services. In the growth stage of an economic cycle, demand typically outstrips the supply of goods, and producers can raise their prices. As a result, the rate of inflation increases.

If economic growth accelerates very rapidly, demand grows even faster and producers raise prices continually. An upward price spiral, sometimes called “runaway inflation” or “hyperinflation,” can result.

In the U.S., the inflation syndrome is often described as “too many dollars chasing too few goods;” in other words, as spending outpaces the production of goods and services, the supply of dollars in an economy exceeds the amount needed for financial transactions. The result is that the purchasing power of a dollar declines.

What is Inflation?

How is inflation measured?

When economists and central banks try to discern the rate of inflation, they generally focus on “core inflation,” such as “core CPI” or “core PCE.” Unlike the “headline,” or reported inflation, core inflation excludes food and energy prices, which are subject to sharp, short-term price swings, and could give a misleading picture of long-term inflation trends.

There are several regularly reported measures of inflation that investors can use to track inflation. In the U.S., the Consumer Price Index (CPI), which reflects retail prices of goods and services including housing costs, transportation, and healthcare, is the most widely followed indicator. The Federal Reserve prefers to emphasize the Personal Consumption Expenditures Price Index (PCE). This is because the PCE covers a wider range of expenditures than the CPI. The official measure of inflation of consumer prices in the UK is the Consumer Price Index (CPI), or the Harmonized Index of Consumer Prices (HICP). In the eurozone, the main measure used is also called the HICP.

Cost-push inflation in context

Both higher oil prices and depreciation of currency have previously caused cost-push inflation,

Example of Higher Oil Prices

First, gasoline, or petrol, prices rise. This, in turn, means that the prices of all goods and services that are transported to their markets by truck, rail or ship will also rise. At the same time, jet fuel prices go up, raising the prices of airline tickets and air transport; heating oil prices also rise, hurting both consumers and businesses. By causing price increases throughout an economy, rising oil prices take money out of the pockets of consumers and businesses. Economists view oil price hikes as a “tax,” in effect, that can depress an already weak economy.

Example of Depreciation of Currency

As a country’s currency depreciates, it becomes more expensive to purchase imported goods – so costs rise – which puts upward pressure on prices overall. Over the long term currencies of countries with higher inflation rates tend to
depreciate relative to those with lower rates. Because inflation erodes the value of investment returns over time, investors may shift their money to markets with lower inflation rates.

What causes inflation?

Economists do not always agree on what spurs inflation at any given time, but in general they bucket the factors into two different types: cost-push inflation and demand-pull inflation. Rising commodity prices are an example of cost-push inflation because when commodities rise in price, the costs of basic goods and services generally increase. Demand-pull inflation occurs when aggregate demand in an economy rises too quickly. This can occur if a central bank rapidly increases the money supply without a corresponding increase in the production of goods and service. Demand outstrips supply, leading to an increase in prices.

How can inflation be controlled?

Central banks, such as the U.S. Federal Reserve, European Central Bank (ECB), the Bank of Japan (BoJ) or the Bank of England (BoE) attempt to control inflation by regulating the pace of economic activity. They usually try to affect economic activity by raising and lowering short-term interest rates.

Management of the money supply by central banks in their home regions is known as monetary policy. Raising and lowering interest rates is the most common way of implementing monetary policy. However, a central bank can also tighten or relax banks’ reserve requirements. Banks must hold a percentage of their deposits with the central bank or as cash on hand. Raising the reserve requirements restricts banks’ lending capacity, thus slowing economic activity, while easing reserve requirements generally stimulates economic activity.

A government at times will attempt to fight inflation through fiscal policy. Although not all economists agree on the efficacy of fiscal policy, the government can attempt to fight inflation by raising taxes or reducing spending, thereby putting a damper on economic activity; conversely, it can combat deflation with tax cuts and increased spending designed to stimulate economic activity.

How does inflation affect investment returns?

Inflation poses a “stealth” threat to investors because it chips away at real savings and investment returns. Most investors aim to increase their long-term purchasing power. Inflation puts this goal at risk because investment returns must first keep up with the rate of inflation in order to increase real purchasing power. For example, an investment that returns 2% before inflation in an environment of 3% inflation will actually produce a negative return (−1%) when adjusted for inflation.*

If investors do not protect their portfolios, inflation can be harmful to fixed income returns, in particular. Many investors buy fixed income securities because they want a stable income stream, which comes in the form of interest, or coupon, payments. However, because the rate of interest, or coupon, on most fixed income securities remains the same until maturity, the purchasing power of the interest payments declines as inflation rises.

In much the same way, rising inflation erodes the value of the principal on fixed income securities. Suppose an investor buys a five-year bond with a principal value of $100. If the rate of inflation is 3% annually, the value of the principal adjusted for inflation will sink to about $83 over the five-year term of the bond.

Key terms to know

Commodities: A commodity is food, metal, or another fixed physical substance that investors buy or sell, usually via futures contracts.
Correlation: A statistical measure of how two securities, such as equities, bonds, commodities, move in relation to each other.
Disinflation: A period of time when economic growth begins to slow, demand eases and the supply of goods increases relative to demand, and the rate of inflation usually drops.
Equities: Ownership or proprietary rights and interests in a company.
Fixed Income: Securities/Investments in which the income during ownership is fixed or constant. Generally refers to any type of bond investment.
Hyperinflation: When economic growth accelerates very rapidly, and demand grows even faster, producers may also raise prices continually.
Income: Money earned on a security from interest or dividends.
Maturity: The date on which a loan, bond, mortgage or other debt security becomes due and is to be paid off.
Stagflation: A period of inflation combined with low growth and high unemployment.

Source: PIMCO https://www.pimco.com.au/en-au/resources/education/investor-education-understanding-inflation

If you have questions and would like your financial situation to be evaluated, please email us on ds@bluerocke.com with your contacts, for an exploratory meeting, at our cost, not yours.