How can high net worth investors use portfolio hedging to maintain generational wealth?
No matter what your investment philosophy is, you have one goal in mind: growth.
Maybe you consider yourself an experienced investor and have a portfolio which you rebalance annually. Unfortunately, market volatility will still threaten your investments. That’s where portfolio hedging comes in.
Portfolio hedging uses financial instruments to offset potential losses. Think of it as insurance for your investments. It might cost you upfront but provides protection when you need it later on.
For high-net-worth individuals and families, hedging isn't just about preserving wealth; it's about creating financial security for your future generations regardless of market conditions.
What is portfolio hedging?
Portfolio hedging is a risk management strategy that uses specific investments and financial instruments to counterbalance potential losses in your portfolio.
While diversification mitigates some risk by spreading your investments across different asset classes, hedging goes further by actively establishing positions that are designed to increase in value when your primary investments decline.
Hedging strategies can be implemented at a few levels:
Portfolio-Level Hedging
Protects your entire investment portfolio against broad market declines through instruments like index options, futures, or inverse ETFs that move opposite to major market indices.
Position-Level Hedging
Protects specific investments in your portfolio. For example, if you hold a large position in a particular stock, you might use options on it to hedge against its decline.
Systematic Risk Hedging
Protects against risks like inflation, interest rate changes, or currency fluctuation through instruments like Treasury Inflation-Protected Securities (TIPS), interest rate swaps, or currency forwards.
Hedging works because it takes advantage of the negative correlations between assets. As one investment loses value, the hedge gains value, creating a counterbalancing effect.
Let's say our client Stuart is a retired executive with a $10M portfolio. 60% is invested in equities that have performed exceptionally well. We implement a hedging strategy using index put options that would increase in value if the market declines significantly.
When a market correction occurs, Stuart’s equity holdings fall by 15% (a $900K loss) but his options hedge increases in value by $400K, significantly offsetting the damage. So, he’s able to keep his planned spending without being forced to sell equities at depressed prices.
Hedging doesn’t remove all losses, but it can reduce their impact.
Who uses portfolio hedging strategies?
Pre-Retirees and Retirees
If you're near or already in retirement, a significant market downturn can hurt your financial security. Hedging provides protection when you have limited time or capacity to rebuild wealth.
Business Owners and Executives
If your net worth is concentrated in a single company or industry, hedging can protect against sector-specific risks that traditional diversification might not address.
Multi-Generational Wealth Holders
If your goal is to preserve your wealth across generations, hedging can help ensure market volatility doesn't throw off your legacy plans.
Those with Significant Tax Consequences
If your portfolio has highly appreciated assets with capital gains, hedging may help you protect value without triggering tax liabilities from selling.
High-net-worth investors recognize the importance of hedging, especially during economic uncertainty or high market valuations.
What are common hedging approaches?
Options Strategies
Put options give the holder the right to sell an asset at a predetermined price, which helps protect against downside risk. More sophisticated options strategies like collars, spreads, and protective puts can be tailored to specific risk profiles.
Alternative Investments
Assets like managed futures and market-neutral funds tend to have returns that are not correlated with the traditional market, offering protection during downturns.
Tactical Asset Allocation
Adjusting your asset allocation based on market conditions and economic indicators can increase defensive positions when risks seem high.
Let's say our client Janine owns a family business worth $15M and has an $8M investment portfolio. Her wealth is highly concentrated, making her vulnerable to economic downturns that could affect both her business and portfolio.
So, we implemented a multi-faceted hedging strategy: we used options on broad market indices to protect her core portfolio, established a line of credit secured by her investments (to prevent forced selling during downturns), and implemented a series of tax-efficient liquidation strategies for her business interest in preparation for retirement.
When recession concerns emerge, Janine’s business valuation temporarily declines but her hedged portfolio stays stable. She has liquidity thanks to her prearranged line of credit, so she can take advantage of buying opportunities without disrupting her long-term plan.
Tax Implications of Hedging Strategies
Short-Term vs. Long-Term Gains
Some hedging instruments (like options and futures) are taxed as short-term capital gains, regardless of holding period. This means they could be taxed at your ordinary income rate instead of the more favorable long-term capital gains rate.
Tax Location Strategies
Placing hedging instruments in tax-advantaged accounts like IRAs can mitigate tax inefficiencies but must be done while following transaction rules.
Wash Sales
A wash sale is when you sell a security at a loss, then buy a “substantially identical” one in the 30 days before or after the sale. If you use hedging to harvest tax losses, you must remember to wait out the 30 day period.
Constructive Sales
Some hedging strategies can trigger constructive sale rules under IRC Section 1259, which might create taxable events even if you don’t sell the underlying asset.
Hedging can seem appealing but it’s important to consider all its ripple effects. Without proper planning, what seems like an effective investment strategy might lead to unexpected tax consequences.
Implementing hedging strategies also requires a shift in how you approach your overall wealth management.
Rather than focusing solely on maximizing ROI, hedging measures performance on a risk-adjusted basis. This means considering not just how much your portfolio returns, but how much risk was taken to achieve those returns.
Because of its basis in inverse relationships, hedging involves trade-offs. Its protection comes with costs that might reduce upside potential. Finding the right balance depends on your specific financial situation and goals.
Hedging isn't a "set it and forget it" approach. You may have a more static investment style, but hedging requires dynamic management. As market conditions, portfolio compositions, and personal circumstances change, your hedging strategy will too.
Lastly, hedging strategies should be coordinated with your overall financial plan. Different strategies will be implemented, for example, depending on your estate planning and whether you plan to leave an asset to an heir or plan to sell it soon and use the profits for a shorter-term goal.
Despite its benefits, hedging does have disadvantages and might not be a fit for everyone. If the cost of implementing and maintaining hedges outweighs their protection, other risk management strategies are likely more suitable.
Hedging strategies aren't about eliminating risk entirely, they're about making risks more manageable. The goal isn't to avoid market fluctuations but to create a more resilient portfolio that aligns with your financial goals.
As always, we recommend working with a tax professional who understands both tax strategies and wealth management.
Author: Rob Cucchiaro, CFP®, CRPC, AAMS
Questions answered in this article:
What is portfolio hedging?
How do hedging strategies protect investment portfolios?
Why do I need portfolio hedging when I am already diversified?
At what levels can hedging be implemented?
Can I only use hedging strategies on my entire portfolio?
Can I use hedging strategies at the position level?
How does portfolio hedging work?
Which hedging instruments are most appropriate for high-net-worth investors?
What tax implications do portfolio hedging strategies have?
When should I not consider portfolio hedging strategies?
How can hedging be integrated with estate planning?
How frequently should hedging strategies be reviewed and adjusted?
Can hedging strategies improve tax efficiency?
What's the relationship between portfolio hedging and liquidity planning?