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.