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DITMo: Hedging without Shorting?

by Peter J de Marigny, DITMo Capital, Newport Beach, CA

In a bull market hedged portfolios generally underperform.  The problem for most investors is that reducing risk requires forgoing upside benefit.  Should reducing risk be a question of diversification only?  This is an approach of many financial advisors using mean variance historical returns to show an “efficient frontier” curve.  The assumptions are simple: Correlations are known and consistent across asset classes and risk is confined to lower moments.

A discussion on risk is outside the purview of this short article (for topical risk articles go to http://garp.org/#!/risk-intelligence) but suffice it to say that factor and other risk models are left to the underlying managers.  Managers are chosen by risk-adjusted returns, tracking error and other factors.  A manager’s “alpha” is the representative metric for any manager (though this assumes a benchmark) which may then be broken down into at least two component parts to reveal its composition: Alpha from stock picking versus Alpha from industry (or other) weighting.

Many advisors will use theoretical optimization charts that include the Capital Market Line that gauges the optimal mix of risk-free and risky assets tangential to the efficient frontier.  The Security Market Line that is used for evaluating individual securities because theoretically, the idiosyncratic risk is unrewarded and only the common risk is rewarded.

Why offer Risk 101 intro to make a point about hedging?  It is important to point out that a hedge fund may mean many things.  In its most basic form it is a structure, but in a fund of funds form it is an access vehicle that may offer dynamic allocation, due diligence and liquidity advantages.  A hedge may be a portfolio of non-correlated assets to equities or bonds, or it may use shorting, derivatives or extraordinary leverage.  Hedged portfolios are susceptible to higher moment risks, and the use of derivatives “games” some of the attribution metrics used in portfolio allocation and selection.

So, how is a hedge created without shorting?  In answering this, a manager well-versed in derivatives will immediately be thinking of synthetic positions of various securities such as a Convertible Bond (a bond and call) or a Forward Rate Agreement.  TIPS have inverse correlations, but aside from short selling there are no major hedge fund strategies (of the top dozen) that have inverse relationships to equities or to one another.  The Barclays Aggregate tends to have slightly negative correlations to the equity market over longer time horizons, and Managed Futures is non-correlated generally.

I offer two paradigms for hedging without shorts:  Risk parity and Pharmaceutical.  Risk parity paradigms seek to allocate by risk rather than using return and correlations.  Correlation is a linear measurement and is assumed to be constant which is a dangerous assumption especially for Liability Driven Investment Policies.  Correlation also misses the mark as a metric in reflecting scale.  Two assets may be highly correlated, but one asset moves 10 points to another’s 1/10th of a point.  Risk parity attempts to optimize by equalizing risk of asset classes to weather any storm of investment environment, equally often utilizing leverage.

Pharmaceutical portfolios are seen by many as hedged portfolios.  This is because the portfolio reflects a low beta, like a long-short equity approach.  Why would a (leveraged) Pharmaceutical portfolio be desirable?  It could be a synthetic hedge portfolio without the fees or higher moment risks.  Also, technology and improved process control in clinical trials mixed with growing demographics may afford an attractive strategy for institutions – pensions and municipalities.  Immunotherapy and many new therapeutics for other conditions are increasingly filling the pipelines.  For instance, a common debilitating condition costing billions in lost productivity is migraines.  Consider the new CGRP peptide therapeutics just coming out of clinical studies and/or just being introduced.  Every time there is a new therapeutic, the old regimens are displaced that may be more expensive and harmful with multiple contraindications.  By introducing more effective, safer, lower cost therapeutics the Pharmaceutical Industry could transform into a technology-valued industry inflating growth expectations and multiples. *.*


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