The IPO train keeps on moving, with GoodRx debuting this week up 53% in its first day of trading and Palantir and Asana set to hit the public scene next week. We continue our spotlight on IPOs by discussing how to de-risk IPO trades and boost your potential alpha in the name.
Hedging as a Tool to “De-Risk” Your Ideas
In the past, we’ve stressed the importance of hedging to remove market and factor risk that may cloud the alpha in investment ideas. Hedging can be done in a number of ways and the most common way to hedge is using broad market or sector ETFs. For example, if a portfolio is net long, a short SPY hedge can be used to hedge out market risk. These types of hedges can certainly be effective, but can also introduce undesired factor risks into the portfolio.
Smart Trading IPO Bets
When trading a security, we are faced with a few choices of how the to take on the risk of the asset. For simplicity, we’ll assume that specific risk, which generally translates to alpha, is “good” risk, and factor risk, which can translate to unintended bets, is “bad” risk.
To illustrate the various options, we built examples of each type of hedge for Facebook (FB), Uber (UBER), HCA Health Care (HCA), and Snap (SNAP) immediately following their respective IPOs.
We rebalanced the factor hedge every 4 weeks for 1 year and compared the risk profile over time to that of a hedge using a broad US market ETF, the iShares Russell 3000 ETF (IWV), and a hedge using a relevant SPDR S&P sector ETF. We then repeated this process for UBER, HCA, and SNAP.
The above table shows the total risk and factor vs specific risk breakdown for the securities and their hedged trades on the IPO date and 2 weeks, 1 month, 3 months, 6 months, and 12 months after the IPO date.
Building Superior Hedges
These simple examples show that factor aware hedge construction can significantly de-risk your bets, especially for securities such as recent IPOs that bear a high degree of uncertainty. While there is no tool that removes all uncertainty behind these investments, we can at least engage in the next best thing by using factor hedges to remove unwanted risk and allow our alpha ideas to be the star of the show.
US & Global Market Summary
US Market: 9/21/20 - 9/25/20
Normalized Factor Returns: Axioma US Equity Risk Model (AXUS4-MH)
Normalized Factor Returns: Axioma Worldwide Equity Risk Model (AXWW4-MH)
Please don’t hesitate to reach out if you’d like to see how Smart Trades can help you hedge risk from IPOs or any other equity positions, or discuss the factor trends that may be impacting your portfolio.