The Finer Points Of Hedging… Or Not

Barry Ritholtz asks the right question—Why hedge?–in the wake of last week’s announcement that California Public Employees’ Retirement System (Calpers), the elephant in the room in the world of pension funds, is ending its decade-long experiment with hedge funds. The allure of these products in the wider world has been driven primarily by the hope that the funds will deliver outsized returns relative to the usual suspects. But smart investors like Calpers have also been drawn to the risk-management aspects of these hedge funds—i.e., low correlations with conventional portfolios of stocks and bonds. After the financial crisis of 2008, the focus on owning stuff that acted differently in times of elevated market stress while offering relatively high expected returns through time required no explanation. But a funny thing happened on the way to nirvana—the results fell short of the sales literature.

The news that Calpers has pulled the plug on its small hedge fund allocation inspires a fresh look at the rising popularity of managing short-term market risks. The key issue for many investors is deciding how to integrate tactical aspects of risk management with the long-term needs of earning a respectable risk premium. Ritholtz zeroes in on the issue, asking the burning question that Calpers seems to have asked and answered with last week’s announcement:

Why does a group with investment horizons of two, three and even four decades, need to worry about hedging short-term investment risk? Consider the investor pool for the typical pension fund: Police, government workers, teachers, firefighters, school personnel, many of whom are in their 20s, 30s and 40s. The investment horizon is a key issue in deciding what sort of risks you are willing to take. The overriding question for this group of investors is how much volatility their portfolio can withstand.

The answer was found in Calpers’s decision. When all was said and done, these beneficiaries simply didn’t need a hedge.

Every investor with an investment horizon measured in years rather than days should be thinking about such topics. The critical decision boils down to this: How much short-term tactical risk management is appropriate so that it enhances rather degrades the capacity to generate positive long-term returns? Going to extremes is almost never a good idea, but that’s what some folks may end up doing in the rush to fight the last war and develop hedges for 2008-type events.

In the pre-2008 era of buy-and-hold strategies, the notion that short-term tactical risk management could be valuable was too often dismissed as market-timing voodoo. It certainly could be, but not always. On the other side of 2008, the focus has swung to the opposite extreme. You can’t swing a stick these days without someone promoting a new risk-hedging process and promising a smoother experience in the next crisis. But a simple principle applies for thinking about this subject: short-term risk management techniques aren’t appropriate as a core holding. That doesn’t mean you shouldn’t have a short-term risk management overlay, but the tail shouldn’t be wagging the dog.

The solution, of course, is to develop a healthy mix of the tactical and strategic. Easier said than done, but thinking about this nexus is essential. You might start by recognizing that in the long run it’s really, really hard to add value over Mr. Market’s asset allocation. Owning the major asset classes in something approximating market-value weights will likely outperform most strategies that try to deliver superior risk-adjusted results over, say, a decade or more. The problem is that most of us don’t have the discipline to sit tight and suffer short-term drawdowns of 25% to 50%.

Adding a risk-management overlay to a portfolio of risky assets makes sense, and it could be something as simple as routine rebalancing. In any case, there are no one-size-fits-all solutions. As always, cost is a factor too. And depending on how you proceed, don’t overlook the possibility that the solution that looks good in the short run could create trouble in the long run in terms of falling short of required results. The devil is very much in the details in the delicate art of hedging risk.

The good news is that there’s no shortage of productive techniques for identifying and managing short-term risks—monitoring volatility or looking for so-called regime shifts that alert us that bull markets may be sliding over to the dark side, for instance. Meantime, there’s a strong case for keeping an eye on the mother of all known risk factors—the business cycle.

Ultimately, the sky’s the limit for hedging risk. Accordingly, the decision about whether to add a tactical risk-management process (or not), and how to proceed falls under the heading of customizing the portfolio design to match the investor’s objectives, risk tolerance, etc. What you define as prudent and necessary may strike me as absurd. Nonetheless, the question must be asked and answered in a thoughtful way: Why hedge?

The answers will vary, and widely so, which is part of the reason why portfolio results are all over the map in the grand scheme of investing. Where to start? With the default solution, if only as a reference point. The average investor with an infinite time horizon should hold Mr. Market’s asset allocation. For the rest of us, we need to develop a customized risk-management process that tweaks Mr. Market’s strategy for our own purposes.

Yes, that’s old news, but one that’s forever new. As last week’s decision by Calpers reminds, wisdom in matters of enlightened risk management has a tendency to be cyclical rather than cumulative.

6 thoughts on “The Finer Points Of Hedging… Or Not

  1. David Stevens

    For truly long-term investors one should also questions why diversify. Over very long periods of time equities and real estate have shown to have higher returns than fixed income. The reason to include them is for risk management and a hedge for when equities go down in value. The beauty of diversification (including the use of hedge funds) is that it may keep investors invested over the long run and not have them abandon growth assets when they periodically drop in value.

  2. Deal Arb

    Let’s say you would like to achieve average 15-20% returns per year, because, say, your pension plan is woefully underfunded against its projected long term liabilities. Doubling your money every 5 years after fees is difficult, to be sure, but it is the best way out of the hole you find yourself in. The greatest threat to averaging those returns are the drawdowns of 10% or more. If you are up 50% and then down 50%, you are not flat, you are down 25%. So, in order to have a chance at outsized returns, you need to hedge. Of course, many hedge funds don’t hedge, and a few hedgers bleed to death rolling insurance. But there are some exceptional hedge funds whose long term Sharpe ratio exceeds 2, who exceed SPX returns, and who double your money every 5 years or so, after fees.

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  4. James Picerno

    Deal Arb, interesting point. The only thing missing: the names of those amazing hedge funds with Sharpe ratios >=2. Feel free to enlighten us at your convenience. As an added bonus, it wouldn’t hurt to have access to the historical returns data that’s been independently verified as accurate.

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