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Hedging for Profit: A Novel Approach to Diversification

Combining bonds with other equity-risk-mitigation strategies may be more efficient than any single approach.

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.

The Author

Jamil Baz

Head of Client Solutions and Analytics

Josh Davis

Global Head of Client Analytics

Graham A. Rennison

Quantitative Portfolio Manager

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PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Irish Branch (Company No. 909462), PIMCO Europe GmbH UK Branch (Company No. BR022803) and PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Italian Branch, Irish Branch, UK Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; (3) UK Branch: the Financial Conduct Authority; and (4) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication.| PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2) . The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser.

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.

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