Hedging for Different Market Scenarios

A look at specific strategies, and their trade-offs, for diversifying equity risk.

More investors are considering broadening their approach to diversifying equity risk to include strategies such as long duration bonds, managed futures, alternative risk premia, and tail risk hedging. However, it’s important for investors to know in what types of environments each strategy is more likely to work and in what environments each are likely to be less effective.

What this chart shows

Not every type of risk-mitigating strategy can be expected to work in every type of market sell-off.

  • High quality sovereign bonds, such as long duration U.S. Treasuries, have historically been an effective hedge during flight-to-quality episodes, but can incur negative returns if interest rates rise faster than consensus expectations.
  • Trend-following strategies have historically performed well in trending markets and could pair well with long duration bonds (for example,  the trend-follower can reduce interest rate risk by shorting rates during a sustained sell-off in rates), but are susceptible to rapid reversals in trends.
  • Alternative risk premia strategies may enhance a trend-following/long duration bonds combination further, as they have the potential to do well in non-trending markets and can act as an uncorrelated return driver. But they can be vulnerable to parallel drawdowns in multiple risk premia, however uncommon these might be.
  • Tail risk hedging may offer a higher degree of reliability, albeit at the expense of short-term return potential. In contrast to the approaches above, tail risk hedging is based on contractual derivatives – not correlations, which can break. And contrary to conventional wisdom, tail risk hedges do not always have a negative expected return or a cost associated with them.

What it means for investors

There is no “silver bullet” strategy to hedge an investor’s portfolio from risk events. We believe that investors should “diversify their diversifiers” by identifying the ideal blend of correlation-based hedges and outright hedges for their unique circumstances.

Source: PIMCO https://www.pimco.com.au/en-au/resources/education/hedging-for-different-market-scenarios