The paper discusses hedging strategies to protect long equity positions in different market conditions. The
desirable property of a hedging strategy is to deliver non‐negative returns (or positive returns) in rising markets and hedge, i.e., deliver profits covering losses of long positions, in down markets.
The paper shows that buying put options provides hedging protection in declining markets, but it is an expensive strategy delivering deeply negative returns in the long run (the performance of such a strategy is illustrated with the Short PutWrite Index). Inverse Exchange Traded Funds (ETFs), similar to put options, have good hedging capabilities in falling markets but we show that these funds are also quite expensive in the long run due to compounding and liquidity effects (this is shown with the performance of SH which is an inverse ETF providing returns opposite to the S&P500).
The paper shows that market volatility is the key factor for building profitable long term hedging strategies. Short volatility strategies benefit from low volatility levels, but during periods of high volatility may be completely wiped out. Long volatility strategies give high returns during market drawdowns when volatility is high but may have inferior performance in bull markets. We show, with an example, that a fund selling naked deep out‐of‐ the money options is a short volatility strategy with spectacular returns in up and sideways markets while in down markets this strategy demonstrates catastrophic performance.
The majority of hedge fund styles are shorting volatility. However, research shows that long volatility strategies, such as hedge funds with a positive loading factor on market volatility, have good hedging capabilities. AORDA® Portfolio 2 is a long volatility strategy providing a statistical hedge for market drawdowns. This portfolio is designed to perform especially well during bear markets while delivering, on average, positive returns in bull markets, in contrast with long put options strategies and inverse ETFs. AORDA Portfolios are based on formal Conditional Value‐at‐Risk (CVaR) risk management optimization technology. CVaR technology is designed to constrain tail loss risk with the objective of growing asset value. AORDA Portfolio 3, which is a mix of Portfolio 2 and the S&P500, performs well in both up and down markets.
The volatility of the market is itself highly volatile, and it is higher during market drawdowns. Several different strategies can be put in place to hedge a portfolio from market movements. Investment strategies that short volatility have good performance during periods of low volatility (in up and side‐ways markets), but are exposed to extreme losses should the volatility sharply increase (in a declining market). Examples of short volatility strategies are short put options, and the PutWrite Index. Many hedge fund styles short volatility.
Buying long put options is an effective way to protect a portfolio in declining markets, but put options are expensive and can cause negative returns in the long run. The Short PutWrite index, discussed in section 2, significantly deteriorated the performance of a long position in the underlying S&P500 after a large market drop. Portfolio insurance techniques are similar to a long put strategy. These techniques are expensive and can cause snowball effects and liquidity problems, as demonstrated in the crash of October 1987.
Inverse ETFs provide good protection against market drops on a short term basis. However, these ETFs do not have good hedging characteristics over the long term. The inverse ETFs may completely wipe out the positive returns of long portfolios, which they are supposed to hedge.
Protecting Equity Investments pdf (1373KB)