Hedging your long-term bets

SMARTSHARE

Billionaire investor Warren Buffett recently made news when his company Berkshire Hathaway (BH), disclosed that it had sold "long-duration equity index put contracts" on four global stock indices.

If the four underlying indices fall by over 30 per cent during the 15-20 year span of the puts, BH will lose about $900 million (at 2005 prices). If the indices drop to zero while the puts are live, BH's total exposure is $14 billion.

No details such as premiums charged, strike prices, European/Asian/ US-style instruments, et cetera, were disclosed in the BH filing.

Without the exact terms, we can't assess the instrument. But in broad terms, it's possible to make sense of the offer. It costs something (between 0.5-2 per cent per month for a strike price within 5 per cent of spot) to buy puts.

BH's offers value to the option-buyer if the premium charged is lower than the standard options. The tenure is astonishing. Most equity/index derivatives are measured in months, rather than years. Even commodity futures rarely run for over 5 years.

The actuarial exercise is tricky. You would have to use some value-at-risk model employing historic return distributions. If index moves are normally distributed, volatility will stay inside two standard deviations of the average move about 95 per cent of the time and within three standard deviations around 99 per cent of the time.

Over a 15-year span, that 1 per cent becomes really important, however. The price may move south and move way beyond three standard deviations sometime in the 4,000-odd trading sessions covered. And even one such southbound move would hurt.

Nobody offers "investment insurance" products in India. If you're hedging, you pay maybe 1 per cent a month to buy a put at 5 per cent strike away from the spot. A hedger pays 10-15 per cent per annum and, if the index loses 5 per cent, the put kicks in. A hedger therefore needs positive returns in the minimum range of 17-22 per cent per annum to pay the hedge and beat the risk-free return.

Given India's historic volatility, the implied volatility is actually on the lower side of fair-value. The Sensex has nearly 20 per cent CARG over its entire 25-year history and the Nifty has similar returns since 1994. You could hedge, pick up deep puts, roll over month after month and still stay in the black if the Indian market maintains its form.

Another method of hedging consists of selling calls at higher strike prices. If the call is struck, sell and book profits; if the price drops, there's some premium to offset the capital loss.

The best hedge for a long-term investor is probably not a derivative at all. It is to allocate a certain proportion of your assets to defensive plays or negative beta shares. Negative beta shares are difficult to find and in a rising market, they tend to be negative beta for reasons such as poor financials or policy risk.

The traditional defensive play is FMCG. However, FMCG valuations are high now. The best defensive deals are probably frontline IT stocks or an IT-sector fund carrying these.

IT shareprices have underperformed for the past year and these businesses have growth rates that justify the current valuations. As and when the market breaks, a portfolio consisting of Infosys, TCS, Satyam and Wipro is more likely to retain value than almost anything else.