Enhancing Portfolio Resilience: Exploring the Impact of Hedging

WealthEngine.AI portfolios have delivered strong risk-adjusted returns over time. However, as any seasoned investor knows, managing risk and drawdowns are key to long-term success. In this post, we’ll explore how the inclusion of gold as a portfolio diversifier or shorting the S&P 500 as risk management strategy can impact the performance of these portfolios.

Diversification with Gold

Gold has long been considered a “safe haven” asset, often performing well during periods of market stress or inflation. Adding gold to a portfolio can reduce volatility and provide stability during market downturns. To test its impact, we allocate 40% of the portfolio to the iShares Gold Trust ETF (IAU) and the remaining 60% to stocks according to our strategies. The allocation is rebalanced monthly to maintain the 40% weight in IAU. Below are backtest results with the WealthEngine.AI portfolios.

Shorting the Market Index

Another approach to managing risk is to short the S&P 500 via the SPDR S&P 500 ETF (SPY). While Gold allocation is a diversification play, shorting SPY acts as a direct hedge against market risk. In this approach, we invest the full portfolio amount in stocks and borrow to short SPY. Unlike the previous approach, here we maintain full investment in stocks, but the net market exposure is reduced as the short SPY position offsets some of the long stock exposure. We rebalance the short position monthly to ensure it remains at 40% of the total amount in long positions. In case of the smallcap portfolio, we use the iShares Russell 2000 ETF (IWM) as the hedge instead of SPY. The backtest results are shown below.

Conclusion

In conclusion, the backtest results highlight the potential benefits of incorporating a defensive component into the portfolios. Both hedging strategies generally demonstrated improved risk-adjusted returns, as evidenced by the higher Sharpe ratio and reduced maximum drawdown. This shows that a well-constructed defensive layer can make a portfolio more resilient, particularly in turbulent market conditions. However, it is crucial to acknowledge the inherent trade-off: this added downside protection often comes at the cost of reducing overall returns. This trade-off between risk reduction and return potential is a critical consideration for investors. Ultimately, the decision to include a defensive component should align with the investor’s risk tolerance, investment horizon, and market outlook.