As one indication that greed is overtaking fear in the equity markets, portfolio hedging activity is plummeting, the Wall Street Journal reports. “I haven’t seen hedging activity this light since the end of the financial crisis,” as Peter Cecchini, chief market strategist at Cantor Fitzgerald, told the Journal. Part of the reason is cost. As investors turn increasing to low-cost index funds and ETFs, active fund managers are cutting back on costly hedging to increase their returns, in a desperate attempt to stay competitive.
In 2017, the S&P 500 Index (SPX) rose 19.4%, the Dow Jones Industrial Average (DJIA) was up 25.1%, and the Nasdaq Composite Index (IXIC) gained 28.2%. So far in 2018, through the open on January 10, their respective increases are 2.9%, 2.4% and 3.9%. Meanwhile, market volatility, as measured by the CBOE Volatility Index (VIX), continues to linger near historic lows, generating a false sense of security among a growing number of investors.
Ironically, penny-pinching investors are dialing back on hedging activity even as the cost of protecting against a short-term stock market decline has fallen to its lowest level in a year, according to data from Credit Suisse Group AG cited by the WSJ. Throughout 2017, as the major market indices rocketed to record high after record high, put options on these indices expired worthless. Emboldened by this experience, increasing numbers of investors apparently are deciding to forgo the cost of portfolio insurance in 2018.
In fact, the analysis by Credit Suisse also may point to increased purchases of bullish call options on the S&P 500 by investors expecting further gains, the WSJ notes. Howard Marella, founder and president of brokerage firm Icon Alternatives, told the WSJ that “Buying dips is still going to be the way to go,” and that he has stopped buying put options as a result.
Hedge funds, meanwhile, are banking on continued low volatility in the equity markets, rather than increased volatility, based on their trading of VIX options contracts, per data from the CFTC cited by the WSJ. Since expectations of low volatility normally coincide with expectations of higher stock prices, this represents a bullish stance on equities, per the Journal.
Some analysts and brokers fear that the decreased use of hedges can increase volatility and exacerbate the next market selloff, as investors liquidate their long positions in stocks to lock in their remaining gains. “When the ultimate disruption occurs, the market is less prepared for it,” as Dean Curnutt, CEO of brokerage firm Macro Risk Advisors, told the WSJ. “That becomes an amplifier of the risk,” he added.
Cautious investors, meanwhile, continue to purchase put options on market indices or individual stocks for downside protection. Selling puts at even lower strike prices can reduce the net cost. Another defensive approach is to shift one’s equity holdings towards lower-risk stocks. (For more, see also: How to Prevent Your Stock Gains From Vanishing.)