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How hedging strategies may help investors in volatile markets

Timely insights on the issues that matter most to investors.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Charles Gaffney, Equity Portfolio Manager, Eaton Vance Management

      Boston - It has been nearly 10 years since U.S. stocks bottomed in March 2009 during the financial crisis. Amid the October sell-off and rising volatility, now investors are wondering if we may be entering another bear market.

      However, trying to accurately time the market by buying at the bottom, and selling at the top, has caused many fund investors to underperform the funds they invest in. This is determined by calculating a fund's actual return against the "average" investor experience, based on the fund's inflows and outflows.

      Morningstar's 2017 "Mind the Gap" study found that the average investor's performance has trailed the returns of the average fund for the previous decade.1 According to the study, the 10-year average annual return for a U.S. investor in a diversified equity fund was 4.36%, while the average diversified equity fund returned 5.15%, for the decade ended 2016. A major part of the average investor's underperformance was due to poor market timing decisions.

      Hedging over timing

      For investors worried about volatility who also respect the difficulty of timing the market, a hedged equity fund may be one strategy to consider.

      These funds provide exposure to the equity markets, but also include a hedge designed to limit downside when markets fall. Eaton Vance's Hedged Stock Fund may write S&P 500 Index call options and purchase index put options to help cushion returns in down markets. This "collar" strategy using index call options and index put options, in conjunction with an actively managed core equity strategy, may allow investors to maintain a commitment to the broad U.S. equity market, while simultaneously protecting them in the event of a sharp market sell-off.

      If the stock market falls, the put options will gain in value, potentially offsetting some of the declines seen in the equity portfolio. However, that put protection does not come free.

      So, instead of paying out of pocket for that protection, the strategy generates income to pay for those puts by selling index call options against the equity portfolio. The end result is a collar strategy in which the investor potentially sacrifices some further gains in the equity markets, in order to potentially protect against severe losses.

      Bottom line: Using a consistent, systematic collar strategy may provide investors with some protection against steep losses in down markets, while at the same time removing the need to accurately time when to buy or sell.