Hedging systematic risk

January 19, 2020

Awareness and prudent management of risks are important for investors to avoid unnecessary and costly losses. In this post, we differentiate between systematic and non-systematic risk and how to protect your portfolio against each.

Systematic vs non-systematic risk

Risk is defined in financial terms as the chance that an outcome or investment’s actual gains will differ from an expected outcome or return.

In general, financial theory classifies risk into:

  1. Unsystematic risk/idiosyncratic risk – risk that affects an industry or a company. This is the risk of losing an investment due to company or industry-specific hazard. Examples include a change in management or a regulatory change that could drive down sales.
  2. Systematic risks/Market risk – risks that can affect an entire economic market overall or a large percentage of the total market. It is risk of losing investments due to factors, such as political risk and macroeconomic risk, that affect the performance of the overall market.

Diversification reduces unsystematic risk but not systematic risk

Unsystematic risk is often managed with diversification. By investing in a diverse range of asset classes, an investor can protect his portfolio from idiosyncratic factors affecting one particular asset class.

On the other hand, systematic risk is that part of the total risk that is caused by factors beyond the control of a specific company or individual. All assets are subject to systematic risk, at varying degrees. Therefore, it is a non-diversifiable risk.

Causes of systematic risk

Any risk that affects the broader market is called systematic risk. This can be precipitate from various factors including:
  • Unexpected inflation
  • Changes in interest rates
  • Currency fluctuations
  • Economic recessions
  • Wars
  • Pandemics
Systematic risk can result from various macroeconomic and unexpected events and would affect the direction and volatility of the entire market.

The effect of systematic risk on an asset class depends on beta

While systematic risk cannot be diversified away, investors can still try to minimize the level of exposure to systematic risk by looking at an asset’s correlation with the broader market (typically the S&P500 Index).

An asset’s beta is a measure of correlation with the broader market and describes the activity of a security’s returns as it responds to swings in the market.

  • A beta of 0 indicates that the asset is uncorrelated with the market.
  • A negative beta indicates that the asset has a negative correlation with the market and moves in the opposite direction of the market.
  • A beta between 0 and 1 indicates the asset historically moves in the same direction as the market, but with less volatility than the market.
  • A beta of 1 indicates that the portfolio will move in the same direction, have the same volatility as the market.
  • A beta greater than 1 indicates that the portfolio will move in the same direction as the market, and with a higher magnitude than the market.

Asset classes with high beta can lose a lot of value when the market turns

Periods where systematic risk is heightened can result in losses across asset classes, but at varying degrees. 

Despite being diversified, a portfolio that has a high degree of systematic risk (e.g. beta >1) is susceptible to large losses when the market declines.

For example, the Invesco S&P 500 Low Volatility ETF (SPLV ETF) has a 5-year monthly beta of 0.70 while the Invesco S&P 500 High Beta ETF (SPHB ETF) has a  5-year monthly beta of 1.59. 

During the 2020 Coronavirus Crisis, the low-beta SPLV ETF declined by 33% in comparison to a decline of 45% for the S&P 500 index and high-beta SPHB ETF. 

Hence, low beta securities tend to hold up better during market crises. As a result, it is important for investors to consider switching to low beta assets when systematic risk is heightened (i.e in bear markets) to mitigate the effects of a market downturn on portfolio values.

So, keep an eye out for low beta investments for bear markets

Low beta assets tend to hold their value when systematic risk is heightened in recessionary periods or bear markets. Some assets even appreciate during these periods.

What are these low beta investments?

Utility stocks

Certain equity market sectors tend to move more closely with the broader market. This has to do with how a company’s earnings relate to the business cycle.

For example, in economic downturns, households would tend to reduce their consumption of luxury and discretionary goods and increase spending back again in good times. Earnings of these companies thus tend to follow the business cycle more closely and this is reflected in stock prices. 

Some expenditure does not get cut despite economic downturns. For example, paying for utilities. In any economic climate, household will still have to pay their utility bill. As a result, earnings from utilities are less affected by the business cycle. Stability in utility firms’ earnings thus translates into stable stock prices, even when systematic risk is elevated.

Government bonds

In volatile markets or when systematic risk is high, investors flock to government bonds. The reason investors flock to government bonds in these times is that governments can increase taxation and/or lower expenditure to pay back creditors. As a result, government bonds are considered “safe haven” assets and are less likely to be affected by systematic risks.

Short duration bonds

Generally, bonds have two different return components:

  1. Return component: Receipt of the promised coupon and principal payments on the scheduled dates
  2. Price component: Potential capital gains or losses on the sale of the bond prior to maturity.

It is important to note that the price and the yield on a bond are inversely related. Generally, when interest rates rise, bond yields follow suit and bond prices fall. To determine the relationship between a bond’s price and interest rate, investment professionals tend to rely on duration. 

Duration rolls up several bond characteristics (such as maturity date, coupon payments, etc.) into a single number that gives a good indication of how sensitive a bond’s price is to interest rate changes. The higher the duration, the more sensitive a bond’s price is to interest rate changes. For example, if rates were to rise 1%, a bond with a 5-year average duration would likely lose approximately 5% of its value while a bond with a 10-year average duration would likely lose approximately 10.

Generally, short term bonds are less sensitive to a changing interest rate environment associated with elevated levels of systematic risk. Suppose interest rates rise today by 0.25%. A bond with only one coupon payment left until maturity will be underpaying the investor by 0.25% for only one coupon payment. On the other hand, a bond with 20 coupon payments left will be underpaying the investor for a much longer period. This difference in remaining payments will cause a greater drop in a long-term bond’s price than it will in a short-term bond’s price when interest rates rise.

As such, to protect portfolios against systematic risk, investors tend to go for short duration government bonds as they tend to hold their value better in volatile times.

Dividend stocks

Some companies would have a long and credible history of paying dividends, even during recessionary periods. The share price of these companies tends to be stable as existing investors would not want to sell-down and lose out on potential future dividends. 

The share price of high dividend yield stocks would also likely appreciate in the longer run. Bear markets are associated with lower interest rates resulting from central banks cutting policy rates. In this low interest rate environment, investors would be searching for yield and would likely buy into these high dividend yield stocks for this yield.

Real Estate

Real estate is another asset class that can provide stability during periods of systematic risk. The main reason is that real estate investments can provide stable source of income. REITs can provide dividend income while direct ownership allows investors to pocket rental income.

Real estate investors can also hedge against inflation and changing interest rates when they have control over rental prices. Raising the rent at lease renewals, allows investors to keep up with rising prices associated with inflation.

The flexibility and predictability of income from real estate thus make it less sensitive to broad market declines.

ETFs enable easy access to low risk assets

During periods of heightened systematic risk, it is important to switch into these asset classes to hedge against broad market declines. However, investing individually in each of these asset classes can be onerous and time consuming.

ETFs offer an easy way to gain exposure to these asset classes in order to hedge your portfolio against systematic risk.

Crea8 can provide you access to a suite of ETFs these asset classes as underlying investments. We have three professionally created investment strategies that can withstand heightened systematic risk episodes:

  • Ultra Low Risk
  • Recession Proof
  • Low risk and High Dividend

Set up an investment plan that is adaptive

You can set up a personalised investment plan that is optimised to meet your personal goals. We give you access to the inflation hedging theme as well as traditional assets to ensure that 

your investment plan is able to withstand periods of elevated systematic risk. If your personal circumstances change, you can update your personalised plan and Crea8 will automatically adapt and revise your optimal portfolio.   

We monitor your plan to ensure you can sleep easy

Your investment plan is rebalanced automatically, or we will send you a reminder to do so. This way, you can relax knowing that your investment plan is able to withstand inflationary periods and remains on track to meet your goals.

Crea8’s Advantage

While non-systematic risk can be diversified away, your portfolio could still have high levels of systematic risk which will leave it susceptible to significant declines in market crises. Being aware of systematic risk and managing it with the right investments is important to protect your portfolio. Crea8 can help rectify this for you through our ‘Inflation Hedging’ theme that is offered via our Goal based investing service.
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