How did hedged portfolios outperform traditional index funds?

For decades, index investing was considered the “holy grail” of the financial community: safe, efficient, and low-cost. But the reality of recent years has shown that traditional index funds are no longer the only or best option. “Hedged portfolios” have proven to be more flexible, more resilient, and, in many cases, much more efficient than traditional index funds. Almost every major writer for the past twenty-five years or so has been repeating the same message: invest your money in index funds and keep costs low. Their mention of risk management has usually been limited to a suggestion of diversification outside of stocks, e.g., placing 60% of your investable funds in stock index funds and 40% in bond funds, or something similar. For decades, this advice worked well. But recent years have shown that there is a better way. A more flexible alternative Let’s look at an extremely conservative example of the hedged portfolio method: a portfolio protected from a decline of more than 4% over a six-month period. The method allowed investors to determine exactly how much risk they were willing to take—and in that case, the sacrifice to minimize the decline was modest but provided competitive returns. But what if you’re willing to take on more risk? This can happen with a portfolio built to be protected from a decline of more than 40%. The value of this portfolio grew from $3 million to just over $5 million—a staggering return of +68.68% in six months, nearly four times the market’s return over the same period. This is no anomaly It would be easy to dismiss this as a fluke. But since we updated our stock selection process in the summer of 2022, the story has been consistent. Every group of hedged portfolios with 20% or greater downside limits—whether they were protected against >20%, >25%, >30%, or >40% declines—has outperformed the market on average. In other words, while this >40% portfolio decline seems spectacular, it’s part of a larger pattern. The Changing of the Guard Index investing was the “new science” of its time. But the evidence from recent years suggests that the hedged portfolio approach is something better: a way to precisely define risk and, on average, achieve superior returns—without sacrificing discipline. Perhaps, as a new generation of investors and writers takes up the mantle, they will move away from repeating the same arguments in favor of index funds that readers have been reading for decades, and consider a method that is more adaptable, more resilient, and, as the data shows, more effective.