Bed & Brexit: Beta Hedging Against the Market

In the last two blog posts I wrote about various approaches to keeping your portfolio safe from Brexit volatility. Obviously the simplest is to Bed & Brexit – i.e. sell before the referendum and buy back afterwards. Each person will have a different cost base though, for instance shares cost more to buy and sell than a spread bet. I also looked at hedging the position with itself. But to me the smart money is to hedge using Beta Hedging against the market itself.

You’ve probably heard of Alpha. That’s the excess return of an investment over and above that which could have been achieved had you simply bought the market. If a given market had risen 6% during the year and you made 10% on an investment then your Alpha is 4%. The FTSE100 over the last year has fallen 7.7% and any gain above that would be Alpha. The Beta value is simply the market return, in this case -7.7%. In the world of investment banking, if you produce no Alpha then you don’t have a job any more: the bank could have not paid your salary and made more money by just buying the market.

We can expect that the market will move, at least in the short term, one way or other based on the outcome of the referendum. Most stocks will simply reflect that market move in relative terms. So we need to sell the FTSE in order to hedge our long positions (and vice versa). It is really helpful if the hedge is in the same account as the position/s because otherwise you run the risk of being stopped out on either or both and it’s not true hedging. But rather two separate positions with increased risk.

How much of the FTSE do you buy? Good question. There are Beta values which are published from time to time by various banks. ShareScope has FTSE100 Beta values which can be added to the portfolio view under ‘Add General Column’. Rolls Royce (LON:RR.) has a Beta of 0.89. Remember these aren’t hard and fast values. They will change very slightly every day, but they’re a guide. They will not help if the stock itself doesn’t move in synch with the market, but most do. It’s all an approximate science when it comes to hedging. For the geeks among you, the formula for the Beta value is:

(volatility of the share) * (correlation of the share with the index share) / (volatility of the index share)

A Beta value of more than 1 means the stock is expected to rise faster than the underlying index, and less than 1 of course means the converse. Rolls Royce is 0.89 which means it moves slightly less quickly than the market. A word of warning: values that are too low or too high, i.e. nowhere near 1, are not very good for use with this method, but typically the large cap stocks will be low figures and usable.

So if we have, going back to the example I used before in this series of posts, 1,000 shares of Rolls Royce at £6 then we need to hedge £6,000 in the market. The index is 1 compared to Rolls’ 0.89, so in fact we need to short only 89% of £6,000, i.e. £5,340. Spread bet exposure is £1 per point on the FTSE100 so with the market at 6,234.0 then £1 per point would give us £6,234. So we only need hedge 85p/point (6,340/5,340). Pretty cheap eh?

Some spread betting companies won’t even let you have such a small stake. You can hedge a whole portfolio in one FTSE100 short like this, just by aggregating your portfolio. If you’re in a SIPP then there are usually some short ETF’s that are eligible to take this role. You’d have to ask your broker about how much to buy. But you can see it’s quite a cheap insurance policy. Even if you had £600,000 in Rolls Royce the hedge spread bet is only £85/point. Although you may run into margin issues, and some spread betting brokers have already increased their margins this week. You have been warned.