Hussman's Market Commentary: Cost of Hedging

Here's a passage from Hussman's latest...

Hussman Funds - Weekly Market Comment: March 6, 2006 - Cost of Hedging

In general, the total return on a fully hedged investment position is: the total return on the stocks owned in the portfolio, minus the total return on the indices used to hedge, plus the short-term interest rate implied in the hedging instruments. In other words, hedging only reduces returns by the amount that the major indices outpace short-term interest rates. (If say, 70% of the portfolio is hedged, you get the total return on the stocks in the portfolio, minus 70% of the index total return, plus 70% of the interest rate).

This is important, because based on the latest record level of S&P 500 earnings, the S&P 500 currently sports a price/earnings ratio of about 18 (the historical average multiple on fresh record earnings is about 12). Even if we assume that 5 years from now, the index merely touches a multiple of 16, and we also assume that earnings continue to grow along the peak of their 6% long-term growth channel, the 5-year average total return on the S&P 500 would only be about 5.44%. The implication here is even if the market continues to deliver positive returns in the coming years,
it would take only a modest normalization in valuations to make full hedging entirely costless. That is, it would be possible to entirely hedge the impact of market fluctuations without sacrificing anything in terms of total returns.