How does Equi’s Hedging Program Work?

TLDR

– Equi’s hedging program was launched in February of this year to mitigate the impact of market drawdowns and protect the portfolio from short-term market risks.
– The hedging program is a balancing act between reducing risk and maximizing the returns of the portfolio.
– Equi tackles this balancing act with a focus on two primary factors: correlation and convexity.

A core component of Equi’s investment mandate is to outperform a public market allocation (ex. S&P 500) over the long run by mitigating impact from market drawdowns, and retaining upside convexity. In order to achieve this aim and protect the portfolio from short-term risks that we may have exposure to through our underlying managers, Equi launched our internal portfolio hedging strategy in February. The goal of this strategy is to protect the portfolio from short-term drawdowns while allowing us to remain fully invested in order to participate in market recoveries. This strategy has performed as intended YTD, up 40% through the end of October, protecting against the handful of managers that have struggled this year, while also allowing us to remain invested in the strategies we believe have embedded upside going forward.

The hedging program is intended to be a delicate balancing act between both reducing risk and maximizing return on the current portfolio of managers, and offsetting any global system risk. The appropriateness of having either higher degrees of protection in our portfolio vs. smaller amounts geared at protecting against potential unforeseen market events is assessed at all times. Equi thinks about this problem in two parts.

Correlation

Historically, the correlation across asset classes tends to pick up and approach 1 during periods of market turmoil (such as what we’ve seen in 2022). We track the correlation between our underlying managers as well as across global asset classes (bonds, commodities, USD, and many others). Generally speaking, we will continue to hedge while the correlation is high and reduce the hedges when we see a decorrelation. This is because when the correlation is high, there is minimal benefit to diversification, due to the fact that as different asset classes decline in tandem they essentially move as if they were just one single trade. We can therefore reduce hedges once diversification “works” again when the correlation drops. The following chart illustrates this phenomenon in action this year, with various asset classes exhibiting similar behavior (albeit with varying degrees of volatility).

(chart source Bloomberg: EUR/USD, US Treasuries, S&P 500 index, High Yield Bonds, Gold, Bitcoin)
Convexity

We use financial instruments with embedded leverage such as options and futures in order to hedge. This allows us to risk smaller amounts of capital to hedge vs. fully negating/canceling manager returns. For example, we could purchase a volatility option to offset risk from our volatility manager. This may cost a lump sum equal to a hypothetical 10% of the expected annual returns of a given manager. In the event volatility spikes, the option could increase 10x and fully negate any negative losses for the manager. In the event volatility declines, we would have therefore reduced the returns of the manager by only 10% from the expected annual returns. This is the notion of using convexity to hedge.

Although this is an oversimplified explanation of the intricacies of our hedging program, it sufficiently illustrates the core principles that guide how we think about protecting our portfolio.

Towards Equilibrium, LLC (“Equi”) and Equilibrium Ventures, LLC (“EquiV”) communications are intended solely for informational purposes. They should not be construed as investment, legal, tax, or trading advice and are not meant to be a solicitation or recommendation to buy, sell, or hold any securities including funds mentioned. Any such offer or solicitation can only be made by means of the delivery of a Confidential Private Placement Memorandum to qualified eligible investors.

EquiV is registered as an investment adviser with the Texas Securities Board Investment Advisers Act of 1940. Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the entity by the Securities Exchange Commission.

Past performance is not indicative of future results and an investment in an investment fund involves the risk of loss. The investment fund is speculative and involves a high degree of risk. The information contained herein is as of the date indicated, not complete and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors, and other terms and conditions contained in the respective offering documents of the respective investment funds.

Before investing in the fund, you should thoroughly review the offering documents with your legal, tax and investment advisors to determine whether an investment is suitable for you in light of your investment objectives and financial situation. An investment in the fund is not suitable for all investors. Performance results are net of all fund and investor adviser expenses and incentive fees, and reflect the reinvestment of interest, capital gains and other earnings. Performance results for 2022 and all subsequent periods are unaudited and are subject to adjustment. The returns shown may vary from the returns for each individual investor based on the timing of capital contributions and/or different fee arrangements.

Asset allocation does not guarantee a profit or protection from losses in a declining market. Investments, when sold, may be worth more or less than the original purchase price.

S&P 500 performance obtained from Bloomberg. References to S&P 500 are included for illustrative purposes only. It is not expected that funds will make investments in S&P 500 companies. Funds are expected to invest with a strategy that is different from a strategy of making equity investments across an index. Accordingly, investors should not expect that an investment would provide exposure that is similar to an index investment in S&P 500 companies or any other specific benchmark.

With any investment, there is a potential for loss as well as profit. The performance displayed is not intended to represent the performance of any particular security. Actual performance of any investment may differ substantially from the back-tested performance presented, as the performance was calculated with the benefit of hindsight and cannot account for all financial risk that may affect the actual performance.

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