Jeff Knight: Conventional diversification may be a disappointing defense against drawdown if many asset classes decline simultaneously, like they did for a time last spring. In light of that scenario, we need other mechanisms to position for stability. That's where hedging comes in. I like incorporating a standing tail-hedging strategy into my portfolios today because the possibility of concurrent declines across many different asset classes is realistic. Monetary stimulus may have elevated all investment valuations simultaneously, so its removal may introduce the opposite effect. That would render simple diversification ineffective, so we need something else to truncate our losses.
Brian Fleming: It's certainly a valid risk management technique. We try not to just pay for protection in our portfolios. At the end of the day, if you continue to pay for downside protection then in the long run you shouldn't expect to be any better off than the risk-free rate. Hedges can be very valid if you want a hard outcome. If you want a floor over a particular period so that your portfolio doesn't go down below a certain level, then having these types of hedges in place can be helpful.
Herold Rohweder: We talk about using available linear derivatives that are liquid and exchange-traded to hedge a strategic asset allocation that has been using indexes where direct hedging instruments aren't available. The problem can be that there is basis risk between the available proxy hedging instruments and the strategic asset allocation. But we highlight these issues with clients.
Brian Fleming: An additional angle might be cross-hedging – increasing investor thinking about whether there are other asset classes or other strategies that I could use that might be a little less obvious. For example, as an equity investor, I might observe that the volatility in the currency markets is low, so I might buy a cross-hedge in the currency market to provide some tail protection.
Jeff Knight: Yes, you could hedge your global equities with S&P options or get more elaborate and hedge your overall risk exposure with yen calls. I see proxy hedging as a silver lining to the dark cloud of increasing correlations. But if you're worried about the decline in a particular asset, sometimes it's better just to sell it rather than relying on a proxy hedge.
Herold Rohweder: This is basically going from an asset class approach to a risk factor approach, and then to an approach where you map the risk factors onto available hedging instruments. So if you think in three dimensions, mathematically speaking, you are trying to map the dimensions onto each other. Proxy hedging is one part of the exercise.
We think you should be looking at the value added of doing cross hedges. You shouldn't bank too strongly on them because these kinds of correlation effects can go away and impact the efficiency of your hedge.
Brian Fleming: That's a good point. A natural conclusion for us would be that you can't always map risk factors onto investments. Taking a view on how a particular strategy or position will behave is much more a fund management decision than a risk management decision.