Advisors often evaluate the cost of hedging correctly but misjudge the benefits because they are comparing a certain cost against an uncertain outcome.

The cost of a hedged equity strategy is explicit, appearing daily in an expense ratio, an option premium or lower upside capture. The benefit, however, is probabilistic and only becomes obvious when markets decline. Because investors naturally overweigh visible costs and underweight avoided losses, evaluating whether a strategy is worth the additional basis points becomes a psychological challenge.

In calm markets, protection looks expensive; in stressed markets, it looks cheap.

No one questions the cost of downside protection after a bear market. The debate only exists during bull markets, which suggests investors often judge protection based on whether it was needed yesterday rather than whether it may be needed tomorrow.


Low Cost ≠ High Value

The financial industry has conditioned advisors to think in terms of relative performance rather than quality outcomes. A hedged equity ETF that captures 80% of a rising market may appear inefficient next to a passive index fund. Yet if that same strategy captures materially less of a severe drawdown, the long-term outcome may be superior despite lagging during extended bull markets.

This fixation stems from a misapplied metric. Goodhart’s law states that when a measure becomes the target, it ceases to be a good measure. While a benchmark measures market participation, the client experiences the actual journey.
The focus on fees is understandable because costs are among the few variables investors can control. However, low cost does not equal high value. Most advisors would not recommend eliminating homeowners’ insurance to save money, nor would they suggest driving without seatbelts because most trips end safely.

While avoiding hedging saves on fees, it may not save money when market conditions deteriorate.

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Maximizing Returns vs. Optimizing Outcomes

For advisors, this creates an important distinction between maximizing returns and optimizing outcomes. They are not always the same objective. A portfolio that captures slightly less upside but materially reduces drawdowns can produce a smoother investor experience, improve client retention and increase the probability that financial plans remain intact.

During periods of market stress, a portfolio that declines less helps investors remain committed to a long-term plan. Avoiding a fear-driven decision can be worth far more than the incremental fee associated with the strategy.


Assess the fire department’s value based only on days when nothing burned down?

Investors can control risk, cost, time and behavior. They cannot control return, yet it remains their primary focus. While return is ultimately what matters, it is a backward-looking measure.

Portfolios are built for an unknowable future, not a perfectly observable past. The S&P 500 has delivered extraordinary returns over the past 15 years. Investors who simply remained invested in broad U.S. equities have seen massive gains. In that environment, downside protection appears unnecessary and tactical flexibility looks expensive.

Historically, downside mitigation looks unnecessary right before it is needed. This reality makes it difficult to evaluate risk-management tools during prolonged bull markets, as they are judged in the exact environment where they are least likely to prove their worth.

The misunderstanding is not the fee itself. The error lies in evaluating a risk-management tool exclusively during periods when risk management was not needed. It is the equivalent of reviewing the value of a fire department based only on days when nothing burned down.

Don’t wait for the next market drawdown to find out if your risk management strategy works. Evaluate the value of your downside defense in the context of your long-term goals.

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About the Author

Eben Burr is the President of Toews where he helps oversee the culture and direction of the firm which specializes in creating strategies designed with the clients financial and emotional wellbeing in mind. Eben has worked in various capacities at Toews since 2009 and before that in real estate in New York City. Eben advocates bringing behavioral psychology, introspection, and empathy into portfolio construction, planning, and communication.  He has a BA in history, studied architecture in Paris, has a master’s degree from Pratt in New York and now lives in Manhattan with his wife, son, and lots of guitars.
 

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