Potential event risks that are not fully priced into financial markets include a US Federal Reserve rate hike at any one of their three remaining FOMC meetings before the end of the year, and/or a victory by Donald Trump at the US Presidential election on 8 November. The remaining FOMC meetings are scheduled for 20-21 September, 1-2 November and 13-14 December. Futures markets currently assign a 22% probability of a rate hike at the September FOMC meeting and still only a 57% probability of a rate hike by the December meeting. The clear implication is that markets are still not fully primed for a Fed tightening this year. The three main drivers of equity markets - bond yields, earnings and valuation - all point to some caution being warranted, with the above-mentioned event risks adding to the uncertainty. Any correction seen in equity markets to date is still fairly minor.

Investors wanting to put some insurance protection into their equity portfolios to cover what could be a risky period through to the end of the year might consider hedging their exposure using exchange listed options or exchange traded funds (ETFs).

Whilst there are many ways of hedging, the simplest strategy for Australian investors is to use either Australian Securities Exchange-listed index options or "bear" ETFs. In the event of equity market downturns, the Australian index tends to correlate quite highly with the US index anyway. However, there is a bear ETF specifically against the US S&P 500 index (currency hedged) listed on the ASX if people prefer that approach or, alternatively, put options against the US S&P 500 index can be bought in the US market. 

The easiest and least capital-intensive way of buying protection is to buy an ASX 200 index put option that expires in the coming months, say in December this year. The further out-of-the-money the index put is the cheaper the premium paid. As an example only, a 5200 strike put option (just slightly below the current index level of 5227.7) expiring on 15 December currently trades at a market premium of circa 166 points, with an implied volatility of 18.2%. Buying one put option contract costs $10 per point - in this example a payment of $1,660. The put option will increase in value if the market falls significantly, at which time one might look to close the position. Care needs to be taken with such instruments as put options though because if the market level is not below the strike price at expiry they will expire worthless.

An alternative way of hedging is by using bear ETFs. BetaShares has three bear ETFs listed on the ASX - the Australian Equities Bear Fund (BEAR.AXW), the Australian Equities Strong Bear Fund (BBOZ.AXW) and the US Equities Strong Bear Fund - Currency Hedged (BBUS.AXW). The exposures are directly against the relevant index futures (minus a 1.19% p.a. management fee), with leverage of 2 to 2.75 times achieved in the case of the "Strong Bear" ETFs.

If following any of these hedging strategies they need to be carefully scaled and managed. If equity markets do fall further then these strategies are a good way of hedging market risk. However, if equity markets rise instead, the payment lost should be viewed as paying insurance premiums against market risk, in much the same way as paying for insurance on your shelter. Please talk to your financial advisor if implementing any of these strategies.

Contributed by Mason Stevens:  (VIEW LINK)