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Perspective

Q2 2022 Hedged Equity Commentary

Although the S&P 500 has declined -19.97% year-to-date, other bear markets have experienced more severe drawdowns. With remaining uncertainty around inflation, earnings, and the ongoing geopolitical stress, the need for consistent risk management and true diversification has never been more important. Many asset allocation models are struggling due to negative fixed income and equity returns and an increase in equity-market correlation across portfolios. The diversification benefits that Hedged Equity can provide continues to merit consideration.

During the second quarter, the investor narrative continued to focus on inflation, with the Federal Reserve tightening and with an increased probability of a recession. The rise in inflation readings early in the quarter was negative for investors, who were hoping to see some reduction in top-line inflation readings due to Federal Reserve hawkishness. Unfortunately, the soft read on Q1 GDP data and elevated inflation readings began to convince equity investors that the traditional FED put (bailing out investors with lower rates whenever GDP dipped), was not a reality. As the quarter progressed, the hopeful narrative that assumed a gentler tightening cycle proved fruitless as the FED announced the end of QE and began the strongest cycle of rate hikes in decades. More problematic for equity markets, what began as an interest rate-based valuation compression cycle to drop PEs, transitioned into wholesale concern that earnings expectations would likely need to be downgraded to accommodate the muting impacts on consumption, due to elevated inflation and the high rates needed to vanquish it.

In this volatile environment, our Hedged Equity strategy provided solid returns, with a gross decline of -3.88% and net decline of -4.18% compared to a loss of -16.11% for the S&P 500 Index. Avoiding over 75% of the market drawdown is consistent with our previous performance during market stress events. Our strategy was designed to consistently meet objectives during market extremes and high volatility environments. The short duration of our put spreads and covered calls provides opportunities to monetize profits and create income.

The continuing need for the Federal Reserve to fight inflation with further rate increases, along with the growing uncertainties around corporate earnings, means the current volatile investment environment will likely continue, showcasing the value of our approach. Hedged Equity’s risk characteristics, our tendency to reduce correlation to the S&P 500 in market declines, while still exhibiting solid market participation under normal market environments, has provided our investors with a smoother ride and improved risk-adjusted efficiency. These traits are shown in our superior Sharpe ratios to the S&P over the past three and five years.

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