How to explain hedging to clients

Hedge

verb Strategy used to offset investment risk (e.g., a stockholder worried about prices dropping can hedge by buying a put option or selling a call option). A perfect hedge is one eliminating the possibility of future gain or loss.

Source: Barron’s Dictionary of Finance and Investment Terms, 7th edition, 2006

noun A protection against possible loss or diminution.

Source: The Canadian Oxford Paperback Dictionary, 2000

This term has deep roots. Hedging has emerged with the global development of agriculture-based futures contracts over the last few centuries.

Basic futures exchanges have existed since the 1700s in Japan, with others appearing in Europe in the mid to late 1800s. The first permanent U.S. futures exchange was created in Chicago in 1874. The Chicago Produce Exchange—now called the Chicago Mercantile Exchange, or CME Group—started as a commercial marketplace where U.S. farmers from across the Midwest struck deals with buyers, who would agree to purchase a set amount of product at a set price in the future. This protected farmers from losses and their buyers from price volatility, allowing both parties to make better investments for the year ahead.

In the last 50 years, the use of hedging strategies and derivatives has expanded beyond agriculture to include different market sectors, multiple types of contracts and various derivatives.

Explaining how hedging works isn’t easy, says Federico Stiegwardt, global base metals risk management head at Minneapolis-based Cargill, where he’s worked with those who trade and transport commodities.

True hedging is related to—but different from and more complex than—simple portfolio diversification, he says. Diversification, where “you spread your investments” to manage exposure, risk and correlation, protects against various market scenarios. Hedging, on the other hand, “is perceived as ensuring one outcome,” since you’re employing a specific strategy to protect against a known risk.

“But it doesn’t mean 100% insurance, and it’s a combination of more than one concept in one word,” Stiegwardt says, adding that using hedging strategies requires familiarity with various asset classes, such as commodities and currencies.

It’s useful, too, to understand strategies that do the opposite of hedging, such as speculating through shorting. Rather than aiming for protection and price stability, as hedging does, this strategy would seek a larger margin.

Complex connotation

No perfect hedge. Dan Mitchell, portfolio manager at RBC Global Asset Management in Toronto, says there’s “no perfect hedge,” since no instrument is a perfect proxy for the risk you’re trying to mitigate.

Mitchell oversees about 80 portfolios, which have had teams managing and monitoring their currency hedging positions daily throughout 2018. “When you try to reduce one risk, like currency risk, you end up inevitably creating others that need to be monitored and managed,” he says. It’s even more complicated in volatile markets, when concerns such as counterparty risk (the risk of the party with which you place a hedge defaulting) come into play, he adds.

An evolving term. The term can be confusing, Stiegwardt says, because “different industries are at different stages” in implementing hedging strategies. Agriculture and foreign exchange are advanced, he says, while steel contracts to ensure stable pricing didn’t exist 10 years ago. The ways in which hedging strategies can be used, and the best practices, are still developing, he adds.

As well, futures contracts and other derivatives are now tied to much more than physical commitments or products. They can also be used to mitigate a transaction’s credit risk or a bond’s duration risk, for example.

Restraint is key

Stick to the plan. Stiegwardt says a plan outlining goals and reporting, a method for identifying risks, and the discipline to stick to the plan are key to hedging strategies. “When people hear stories about something that supposedly should have been hedged or where a strategy didn’t work, there are plenty of cases of organizations straying from the original plan,” he says.

Don’t forget about cost. Fees are always a factor when investing, and hedging is no different. Along with the fees that result from trading more often, costs such as option premiums can affect the overall balance sheet. It also matters whether you’re hedging globally or domestically, if you’re factoring in the potential costs of hedging foreign currencies.