Active Hedge Overlay Example

For the purpose of this example, let’s say the portfolio value is $1,000,000 and the average computed beta is .75 (volatility) relative to the S&P 500 Index.   We will also assume for the purpose of this example that the beta of Nasdaq Composite Index (our only hedge in this simplified example) relative to the S&P 500 is 1.2.  The amount needed to hedge a $1,000,000 portfolio is computed as follows:

(Portfolio Beta / Nasdaq Composite Beta) times the amount to be covered = Active Hedge Overlay amount

(.75 / 1.20) * $1,000,000 = $625,000

If two times leverage is used, the amount needed can be lowered to $335,142.85.  That amount is reached by dividing $625,000.00 by a factor of 1.75 instead of 2.  This allows for higher expenses and tracking errors that can occur with leveraged funds.

As a general rule the higher the beta of a client portfolio, the more funds are necessary to cover the portfolio Active Hedge Overlay strategy.  Conversely, a lower beta portfolio will require fewer dollars to cover the portfolio utilizing the Active Hedge Overlay.
Disclosures:

The betas listed above are for this example only and are subject to fluctuation with market conditions.  This example is hypothetical and is a simplified version of what is typically used to determine client exposure.

The S&P 500 is a capitalization weighted index of the 500 leading companies from leading industries of the U.S. economy.  It represents a broad cross-section of the U.S. equity market, including stocks traded on the NYSE, Amex and Nasdaq.  The S&P 500 TR index includes the effect of reinvested dividends in its returns.

The Nasdaq Composite is a stock market index of all of the common stocks and similar securities (e.g. ADRs, tracking stocks, limited partnership interests) listed on the NASDAQ stock market, meaning that it has over 3,000 components. It is highly followed in the U.S. as an indicator of the performance of stocks of technology companies and growth companies.