Hedging for possible interest rate caused market downturn

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I was wondering what, if anything at all, different investors use to “hedge” their portfolion against market downturn. Do any of you “hedge” somewhat?

Situation:
The companies I invest in tend to be fairly valued (in my opinion) however I do think that in general the market could undergo a significant correction in the medium term, particularly if interest rates go up (and therefore the “risk-free rate” and market multiples come down). Such a downturn would probably impact the whole market, although hopefully fairly valued companies wit good cashflows should recover.
So I was considering setting aside some of my money in a “hedge” that may allow me to “deploy it” (sell and invest it) in the case of a market downturn. Any ideas?

I thought I’d create this post to discuss the topic and different investors’ opinions/choices as well as potentially “brainstorm”.

Thought process I went through :
1st Option considered: Bonds
The obvious option that comes to my mind is bonds as a diversification and also as a hedge. Developed-government bonds acted quite well in the covid correction in March 2020 (although it varied with the bond term). However, if the downturn is caused by interest rates rising, bonds are likely to do very poorly as increasing bond yields leads to lower bond values.

2nd Option considered: Put Options
An alternative could be buying “put options” but these are expensive and time-dependent and who knows when the next market correction could be, so it could require buying regular put options which is likely to be quite expensive and not be financially viable - unless you are fairly confident of an upcoming market correction.

Option considering now: Company that may benefit from market downturn
As such, I was thinking that investing in a company that may benefit from a stock market downturn may be the best option.

Aim: To potentially invest say 5% of my portfolio in a stock that would operate normally and be a good company with growth or dividends, etc and that at the same time could appreciate in price in case of a market crash providing liquidity for me to invest in other stocks. Say for example I invest 5% and it goes up 30% in the case of a crash, I would then have 6.5% of my original portfolio value that I could sell and use to invest in the market at lower prices.

It would have to be something that in the event of no market crash ie. in a normal upward trending or flat market could still provide acceptable returns. The idea would be similar to investing in a sausage company in a recession, when consumers may change from buying expensive meat to buying the cheapest (potentially sausages).

What do you think of this idea?
Do you have any suggestions?

I would be interested in any company :smiley: .

Having said that, I think that it is likely that there are some hidden small caps that might be quite interesting as a hedge, if anyone is aware please mention :slight_smile: .

The only company that came to my mind: Flow Traders - it is a company that as I understand mainly provides liquidity for ETFs and ETPs. @Etypsyno did a video on it a while ago (post shared beIow) and mentioned that in a downturn it benefits from higher volumes and higher spreads (ie. higher revenue and higher profit margins).
I am yet to look into it deeper though, but it may be a possible option.

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Personally, either you hedge long term as part of your investment strategy, or not at all.

I would google the difference in performance returns between hedged/unhedged positions.

The variations can be quite big in the <10 year range, but after that the performance is generally the same, with a hedged strategy typically returning slightly less due to the costs associated with doing so.

I wouldn’t start a short term hedge strategy now. Typically markets over react to both good/bad news, and adding a hedge in now without a long term reason for doing so, you are potentially crystallising part of your exposure now for better or worse.

Another thought could be Inverse ETFs.

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I prefer the simplest way, e.g., an Inverse ETF of tech stock / NASDAQ such as SQQQ TQQQ. But only for a short time, so after all of the uncertainty has been cleared I will sell it.
Option is not available in the UK. So you will need to set up a new account just for this purpose.
Also investing in Gold, Gold Mining and all of its derivatives to hedge against inflation which is very related to Interest rate hike.

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Longer-term hedges:
Stocks that facilitate trading would generally benefit from higher volumes as you mentioned. MarketAxess, Flow Traders, Virtu Financial among others come to mind in such a scenario (exchanges and brokers to some extent). These former tend to underperform in low volatility or volume environments in financial markets so keep that in mind.

Precious metal miners also tend to benefit from inflationary or crash-like scenarios (take gold as an example), with the miners you don’t have the drawbacks of holding unproductive commodities through futures or storage costs.

Perhaps most realistically if you expect rate hikes you could hedge by allocating more to banks or insurance companies.

All in all your long term hedge really depends on what you would expect:

  • Inflation: materials, energy, real estate, consumer discretionary
  • Interest rate hikes: banks, insurance
  • Heightened volatility: precious metals, liquidity providers, consumer staples, utilities, telecom
  • Low-interest rates, low inflation: tech, healthcare, consumer staples, utilities