Chief Investment Quarterly

You Can’t Hedge, but You Can Diversify

Topics - Asset Allocation Portfolio Construction Equities Hedge Funds Risk Parity

Read Time - 3 min

${ numberSection } ${ text }
You Can’t Hedge, but You Can Diversify

We all want to sleep well. We all want the perfect investment – the one that offsets equity market losses but still makes money in the long-run. We can’t have it. We can’t really hedge.

We can’t hedge because it’s too expensive. Hedging is a bet against risk taking, and while not all risk taking is profitable, betting against the risks you want to take almost certainly isn’t. Hedging stock market risk, for example, means pretty much one thing—selling stocks—with all the negative expected return that brings. 1 1 Close Hedging unwanted risks is a different matter and is often useful in investment strategies that seek certain risks and want to avoid others.

The critical difference between hedges and diversifiers is their correlation to what you already own. To hedge, you need a highly negative correlation. To diversify, you merely need a correlation that isn’t highly positive. Practically speaking it’s pretty difficult to hedge without outright shorting the thing you are trying to hedge, or something very similar to it. For example, if you want to hedge MSCI World exposure, you might be able to do a reasonably good job of it by selling S&P 500 futures, but once your hedge gets too “creative,” eventually you may end up pretty disappointed.

While it’s true that an investment can be a little negatively correlated to bad markets and still maintain a positive long-term expected return, that little bit of negative correlation only can provide great diversification, not a hedge.

When markets are down, what’s different between a hedge and a diversifier? In the graph below, we show what might happen to four hypothetical portfolios (a stock hedge; an uncorrelated alternative strategy; a diversified long-only portfolio; and, a “Texas hedge”) when stocks are down 10% in a year versus cash.

Sources: AQR. Long-term return, volatility and correlation expectations stock market, stock hedge, uncorrelated alternative, diversified long portfolio and Texas hedge strategies are based on assumptions provided in the disclaimers. The expected return given portfolio loss and probability range for the given portfolio loss are determined using the properties of jointly normal distributed random variables. Where the conditional expected return is based on the strategies expected long-term return plus the contribution from its relationship to the stock market. The probability range is the conditional distribution such that 80% of outcomes fall within these bands and are normally distributed around the conditional expected return, as illustrated by the shading. For illustrative purposes only and not representative of any strategy that AQR currently manages. The information generated regarding the likelihood of various investment outcomes is hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. No representation is being made that any asset manager, fund, or account will or is likely to achieve profits or losses similar to those shown herein. In fact, there are frequently sharp differences between hypothetical results and the actual results subsequently realized by any particular model. There is no guarantee, express or implied, that long-term return and/or volatility targets will be achieved. Realized returns and/or volatility may come in higher or lower than expected. Hypothetical data has inherent limitations, some of which are disclosed in the disclaimers.

Show more

The first column is the “stock hedge,” which is assumed to have a -0.99 correlation to the underlying portfolio and typical stock market volatility (about 15% 2 2 Close Source: AQR. The average annualized volatility for developed market stocks for the last 40 years. ). Note the expected excess return for this hedge is negative (the -5% diamond), as we should expect if we are short something that makes money in the long-term. Now, given the -10% excess return on stocks, what is the range of outcomes for the hedged position? With a correlation of -0.99, we expect an excess return of about +10%, with some small variation. We show the middle 80% of the range of that variation (+8% to +12%) with the blue-boxes. 3 3 Close Note that had the correlation of the hedge been -1, then we know exactly what it would have done – it would be up 10% with no variation around that. So even with a highly negative correlation, there is still a range around the return of the hedge, even though the return is still highly likely to be positive. This behaves like we expect a hedge to behave; it’s very likely to do well when the thing we are hedging does badly. But recall one important fact – the long-term expected return of this asset is negative.

The next bar represents an uncorrelated alternative investment with the same risk-adjusted excess return as the stock market but with slightly lower risk (about 10%). Knowing how the stock market performs tells us nothing about the return of the uncorrelated alternative. 4 4 Close Quick aside: There are lots of diversifiers that are uncorrelated on average, but don’t stay uncorrelated in periods of stock market stress. Strategies that get more correlated as markets fall, like short-volatility, would be expected to underperform their long-term return target, while other strategies can become less correlated, like trend following, and would be expected to outperform. For the purposes of this stylized example we assume our diversifier’s correlation remains fixed, but it is important to be cognizant that correlations aren’t always static. That’s a pretty good thing; we still expect the alternative investment will make money on average, and it might even do well in this particular period. But notice the middle 80% of the expected outcomes is still large (-9% to +16%) and includes the possibility of negative returns that are similar in size to the poorly performing stock market. While this is still a great thing to hold (it helps us create a portfolio that may improve the odds of meeting our objectives), it isn’t a hedge. It might well go up, but it’s not going to go up because stocks went down.

Next, we examine another realistic investment, a diversifier that is positively correlated to the stock market, possibly because it includes some of the same assets (see Diversified Long Portfolio in the figure). A good example could be a risk parity portfolio. Here, with the stock market down 10%, this portfolio (which we are assuming to have a +0.65 correlation to stocks) is expected to have a small loss. The diversified portfolio might make money, or it might even do worse than the stock market, but it still provides an important long-term benefit. It’s better than just owning more stocks in this hypothetical bad year since it’s still likely to outperform (even though outperforming might mean losing money) and on average it makes money. Nevertheless, it is most definitely not a hedge.

Finally, we come to the Texas hedge (the last bar in the figure). We sometimes call it “private equity”, but to be fair, it also describes the subset of hedge funds that have a lot of net market exposure. 5 5 Close See “Do Hedge Funds Hedge?” Cliff Asness, Robert Krail, John M. Liew, September 1, 2001. It’s called the Texas hedge because it’s akin to a rancher buying cattle futures to “hedge” the herd; it is highly positively correlated to the underlying portfolio. If you want to hedge your risk by doubling up on it, then the Texas hedge is for you. No doubt it can provide some excitement and add to returns (if everything works out well), but it’s obviously not a hedge and isn’t even a diversifier.

Through these examples, we’ve tried to show that for the long-term, we can usefully diversify, but when the market is down, “diversifiers” won’t always help. If we want that guarantee, we have to hedge and pay for it with lower return expectations. Few investors can afford that; they can’t really hedge.

 


Disclaimers
Selected Strategy Assumptions:
 
This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable, but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is intended exclusively for the use of the person to whom it has been delivered by AQR, and it is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance.

This presentation is not research and should not be treated as research. This presentation does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR.

The views expressed reflect the current views as of the date hereof, and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. It should not be assumed that the author or AQR will make investment recommendations in the future that are consistent with the views expressed herein or use any or all of the techniques or methods of analysis described herein in managing client accounts. AQR and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this presentation. This analysis is for illustrative purposes only. This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor. The recipient should conduct his or her own analysis and consult with professional advisors prior to making any investment decisions.

The information contained herein is only as current as of the date indicated and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice, nor is it to be relied on in making an investment or other decision.

There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment, which may differ materially, and should not be relied upon as such. Target allocations contained herein are subject to change. There is no assurance that the target allocations will be achieved, and actual allocations may be significantly different than that shown here. This presentation should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy.
The information in this presentation may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein and is only current as of the date indicated. There is no assurance that such events or targets will be achieved and may be significantly different from that shown here. The information in this presentation, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Performance of all cited indices is calculated on a total return basis with dividends reinvested. Diversification does not eliminate the risk of experiencing investment losses. Broad-based securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation. Please note that changes in the rate of exchange of a currency may affect the value, price or income of an investment adversely.

Neither AQR nor the author assumes any duty to, nor undertakes to update forward-looking statements. No representation or warranty, express or implied, is made or given by or on behalf of AQR, the author or any other person as to the accuracy and completeness or fairness of the information contained in this presentation, and no responsibility or liability is accepted for any such information. By accepting this presentation in its entirety, the recipient acknowledges his or her understanding and acceptance of the foregoing statement. The data and analysis contained herein are based on theoretical and model portfolios and are not representative of the performance of funds or portfolios that AQR currently manages.

Diversification does not eliminate the risk of experiencing investment losses. There is no guarantee, express or implied, that long-term return and/or volatility targets will be achieved. Realized returns and/or volatility may come in higher or lower than expected.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH, BUT NOT ALL, ARE DESCRIBED HEREIN. NO REPRESENTATION IS BEING MADE THAT ANY FUND OR ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN HEREIN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY REALIZED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS THAT CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS, ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

Broad-based securities indices are unmanaged and are not subject to fees and expenses typically associated with managed accounts or investment funds. Investments cannot be made directly in an index.
MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets.

The S&P 500 Index is the Standard & Poor’s composite index of 500 stocks, a widely recognized, unmanaged index of common stock prices.

There is a risk of substantial loss associated with trading commodities, futures, options, derivatives and other financial instruments. Before trading, investors should carefully consider their financial position and risk tolerance to determine if the proposed trading style is appropriate. Investors should realize that when trading futures, commodities, options, derivatives and other financial instruments one could lose the full balance of their account. It is also possible to lose more than the initial deposit when trading derivatives or using leverage. All funds committed to such a trading strategy should be purely risk capital.