SIMON BROWN: The pros and cons of hedging

Hedging is using derivatives to lock in current asset prices, and it can be used by corporates and individuals alike.

For example, you hold shares in a stock and you’re worried it’ll fall in price. So, using futures, options or contracts for difference, you open a short position that would profit from a falling price. The theory is that the stock loses, say, 10%, but the hedge makes you 10%, so you haven’t suffered any actual loss.

But I have concerns.

First, we’re ignoring the costs involved, which could easily be more than 1% just for the transaction (buy and sell side). Add in the spread (difference between buy and sell prices on the JSE) and you could potentially add another 1% to the costs. And then there is tax — at best you pay capital gains tax on the derivative profit, but more likely the South African Revenue Service would consider it trading and you’ll pay your marginal tax rate. Suddenly the 10% profit from the hedge is a whole lot less.

But the bigger question is why. If you are a short-term trader, why hedge? Just close the position. If you are a true long-term investor, why worry? Stocks never go up in a straight line and pullbacks of 10% or more are going to happen from time to time. If the core fundamentals of the stock haven’t changed, then just hold on during the pullback and wait for the stock to start rallying again. Yes, the wait can be long and the sell-off steep, as we saw in the bear market in the US in 2022, but quality stocks do recover in time.

For corporates, hedging can serve a useful purpose. Say you’re a logistics business. One of your big expenses would be diesel and you could hedge your diesel cost to create some certainty in your costs. Using derivatives, you could work out how much diesel you expect to use for the year ahead and hedge it, at a cost to the business. But it does give you certainty about your diesel expenses for the year.

Maybe you’re a gold miner and you are worried about the gold price falling, so, using future contracts, you sell your next year’s gold production. If gold falls, you’ve locked in the higher price. Of course, if it rises, you lose out on that upside.

But here’s the real issue with hedging for a corporate: aside from the expense of the hedge, it is also only for a limited time. You can’t really sell the next decade’s gold production or hedge the current diesel price for the next decade without ensuring extreme costs. So eventually, and usually after a year, the hedge expires and you’ll need to hedge again at the new prices and with a new set of costs.

So, sure, for the corporate a hedge helps, but only in the short term. For the investor, hedging has never really made sense to me, neither from a cost nor protection perspective.