Is Hedging the New Diversification?

(February 17, 2012) — Many institutional investors have given up on diversification in favor of hedging as they rethink the risks associated with portfolio construction in the wake of the global financial crisis, a recent whitepaper by BNY Mellon Asset Management concludes. 

A more thoughtful approach to portfolio construction will include value-conscious hedging, the paper titled “Is Hedging the New Diversification?” concludes. Robert Jaeger, a senior investment strategist at BNY Mellon’s Investment Strategy and Solutions Group and author of the paper contrasts diversification versus hedging by outlining the following points:

First, he says diversification didn’t fail during the global market meltdown, and not all correlations went to one. “Rather, investors weren’t adequately diversified: they owned a long menu of risk-on assets (oriented toward generating return) but not enough risk-off assets (oriented toward safety and liquidity),” Jaeger concludes. 

Secondly, diversification is based on low correlation, while hedging is based on negative correlation. Therefore, the ideal hedging asset is either an option or an option-like asset that can deliver asymmetrical returns. The mantra that “diversification is the only free lunch in investing” is true in one sense but not another, as diversification involves the blending of risks. It’s not scooping up $100 bills lying on the sidewalk, the paper asserts. 

Third, Jaeger explains that hedging is best viewed as a tool for reducing risk, not for improving the return/risk tradeoff. 

Finally, the paper explains that diversification is often viewed as a long-term strategy vulnerable to short-term shocks, whereas hedging is often viewed as a more opportunistic strategy designed for short-term protection. 

The author asserts that the current interest in hedging against downside risk underestimates the explicit and implicit costs while overestimating the protection it provides. “When home-owners buy fire insurance, houses do not thereby become cheaper or more flammable,” he says. “But when investors flock to portfolio protection assets, those assets become expensive and the assets they’re trying to protect may become attractively cheap.”

The paper by BNY Mellon Asset Management comes after consultants have voiced their aims to increase derivative use to hedge against interest-rate risk in the future. “We’ve seen a growing number of especially corporate pensions using derivatives as they pursue liability-driven investment,” Strategic Investment Solutions’ Managing Director John Meier told aiCIO in October. “If you’re trying to lower pension surplus interest rate risk, using derivatives is definitely effective in order to maintain a reasonable level of return.”

Mercer consultant Gordon Fletcher voiced a similar perspective, noting that he has witnessed a much greater interest in derivatives among corporate funds as they look into derisking strategies amid an environment of frozen legacy liabilities.

Currently, however, schemes in the US and the UK aren’t widely using derivatives to effectively hedge against inflation risk, but they could be, Meier told aiCIO. “Inflation risk is a risk that institutional investors are increasingly focused on. With the markets reflecting an expectation that inflation will remain at current levels, the cost for hedging now is pretty low. This could be a good time to hedge against inflation and especially though the effective use of derivatives.”