Hedging for Profit: A Novel Approach to Diversification
Summary
The key to mitigating equity risk in portfolios is investing in assets that are negatively correlated with equity markets yet exhibit the potential for a positive expected return. For most of the past 20-plus years, bonds have fulfilled this role in portfolios, aided by a substantial tailwind of stable or falling inflation. On a forward-looking basis, bonds will continue to be a key part of portfolios, but the potential for both positive expected return and negative correlation with equities may be tested at times. Beyond fixed income, the search for positive-expected-return, risk-mitigating assets becomes more challenging.
With stocks hitting record highs, many investors want to mitigate the largest source of risk in their portfolios – equities. In recent decades, fixed income has served this purpose well. The asset class has generally delivered both positive returns and negative correlations with equities. However, our research finds that combining additional asset classes may enhance the diversification and efficiency of hedging portfolios.
As the number of strategies increases, for instance, the expected Sharpe ratio of the risk-mitigating portfolio improves, and its expected correlation with the market decreases.
Common risk-mitigating approaches
Investors commonly deploy three types of equity-risk-mitigation strategies: bonds, trend-following and tail-risk hedging. Each has potential costs and benefits:
- Fixed income: Bonds are the classic counterweight to equity risk. They deliver the potential for positive returns with negative correlations to equities. Yet these correlations can change, sometimes abruptly. Furthermore, with the secular decline in yields since the early 1980s, many investors fear a reversion to high yields (and lower prices) as unemployment shrinks and money supply grows.
- Trend-following: These strategies seek to benefit from the persistence of trends in financial markets. Historically, they have delivered positive returns, on average (based on the SG Trend Index), and have performed strongly in more extended market declines. Yet because trend-following strategies typically require a week or two to adjust positions, they are susceptible to gapping markets – the starkest example being the October 1987 “Black Monday” crash.
- Tail-risk hedging: This approach uses options to mitigate tail events (rare but severe market moves) and provides the highest confidence in delivering returns when needed. Yet expected returns of tail-risk hedging are highly dependent on valuations. If options aren’t exercised, they expire without value, the premium lost forever. Options additionally carry a financing cost which can be a drag on a portfolio.
Broadening the menu
Our research suggests that additional diversifying strategies may be discovered by scanning markets, filtering for value and carry. For instance, a systematic approach may identify expensive, negative-carry risky assets to short, and cheap, positive-carry countercyclical assets to buy.
Note that all hedges described in this paper are statistical in nature and, like all relationships derived from historical data, may perform differently in the future. However, this only strengthens the case for a diversified approach to risk mitigation.
For a deeper dive into our methodology and results, please visit “Hedging for Profit: A Novel Approach to Diversification.”
Jamil Baz is a managing director and co-head of PIMCO’s client solutions and analytics team.
Josh Davis is an executive vice president and senior member of PIMCO’s quantitative strategies portfolio management team.
Graham Rennison is a senior vice president and portfolio manager focused on multi-asset-class systematic strategies.
Featured Participants
Disclosures
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Trend following strategies may utilize quantitative models as part of implementing their investment strategies. These models evaluate securities or securities markets based on certain assumptions concerning the interplay of market factors. Models used may not adequately take into account certain factors, may not perform as intended, and may result in a decline in the value of your investment, which could be substantial. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.