Cliff Asness

Cliff Asness

Why Bother to “Hedge” at All if You’re Long-Term

Of course, in building a portfolio one doesn’t have to choose between stocks, bonds and hedge funds. One can and should be building a portfolio of the best combination, not looking at individual asset classes or artificially limited combinations.

A particularly misguided question related to this, in that it fails to grasp that one is building a portfolio not choosing the best single investment, is “why bother to hedge at all if you’re long-term?” I mean, long-term investors shouldn’t eschew but embrace risk as that leads to higher returns, right? And hedging is running away from risk, no? This argument, made in some of the links cited above, misses some crucial things basic to portfolio construction.

In building an optimal portfolio, all investors should look for investments that produce long-term positive returns (note, this is not the same thing as saying they always work) that aren’t very correlated to what they already own (say, stocks). The observation that a long-term, or for that matter a short-term, investor shouldn’t want merely a “hedged” portfolio is true. They should want a portfolio that hedges away the risks they already bear (say, stock market risk) and includes other sources of return not very correlated with those risks. They should want that regardless of time horizon. (I address later the issue of paying alpha fees for beta performance.)

Now I’ll look at a portfolio that’s ex post optimal over this 1994–2014 period. Now, ex post optimal always overstates how good things could have been (it’s ex post after all). It takes small victories and sees them as certainties, as we are looking backwards. But, if we can keep that in mind, I think it’s still instructive to see what these optimal portfolios look like. In other words, what would we have done if we knew what would happen over the 1994–2014 period to these asset classes?

I’ll run a simple optimization looking at the 1994 to 2014 data. The optimization looks for the highest compound return allocating passively (not changing this allocation around intra-period) across stocks, bonds, and hedge funds, without allowing leverage, and limiting realized volatility of rolling annual returns to that of the 60/40 portfolio (using annual instead of monthly volatility again just biases it a bit against hedge funds). When you do this you get the rather radical portfolio of 31% in equities, 0% in bonds, and 69% in hedge funds (yes, I’m usually the one talking about how important more bond diversification is, that’s coming soon). The results look like this:

StocksBonds60/40Hedge Funds31/0/69
Compound Return9.3%5.9%8.3%8.7%9.1%
2008-37.0%5.4%-22.0%-19.0%-24.8%
Full GFC-49.2%10.4%-30.0%-17.1%-28.2%
Worst Drawdown-51.0%-5.2%-32.5%-20.5%-31.0%
201332.4%-2.0%17.6%9.4%16.1%
Last 10 Years7.8%5.0%6.6%6.1%6.7%

 

I do not claim that many would undertake this portfolio, which is mostly hedge funds plus some straight equity. But it is the optimal one, subject to my conditions, over this period, and it did produce reasonable results over the last 10 years, a period used by some to criticize hedge funds. Incidentally, the last column shows that what worked “optimally” well for 20 years would still have done pretty poorly in 2008 — you’ll have to wait until the next section to see that change for the better.

Now Let’s Get Crazy

The results above might appear confusing, particularly the non-existent role of bonds in the optimal portfolio. They might appear especially confusing given my full-throated defense of the role of bonds in other places. But I snuck a constraint into the optimization above — no leverage allowed. Without leverage hedge funds replace bonds as the most attractive low risk asset over this period (remember, hedge funds are correlated with equities but are still low beta making them a candidate for a low risk asset). Now let’s re-run the exact same ex post optimization and volatility target but lift this no?leverage constraint. Well now the optimal portfolio is 0% equities (yes, 0%), 227% bonds (yes, 227%), and 90% hedge funds (yes, 90%). While there may be practical issues, perhaps fewer than you might think, you’ll see below that this has not been a particularly dangerous portfolio compared with the others. What’s going on here is hedge funds are a combination of equity exposure and “other strategies,” and since they come as a package you don’t need equities directly anymore. With leverage allowed you can now obtain the one thing equities uniquely offered, aggressive returns but with a more diversified portfolio (equities still uniquely offer this aggressiveness without explicit leverage, but remember that they have plenty of implicit leverage). Hedge funds are seen as equity related but better substitutes, and the role of the low risk asset re-emerges for bonds as with leverage they can be held in enough size to matter. The next table looks at how this portfolio would have performed:

StocksBonds60/40Hedge Funds0/227/90
Compound Return9.3%5.9%8.3%8.7%15.3%
2008-37.0%5.4%-22.0%-19.0%-10.5%
Full GFC-49.2%10.4%-30.0%-17.1%-2.9%
Worst Drawdown-51.0%-5.2%-32.5%-20.5%-23.1%
201332.4%-2.0%17.6%9.4%3.2%
Last 10 Years7.8%5.0%6.6%6.1%13.8%

 

Yeah, those results are kind of silly good. It’s what you get from combining the benefits of risk parity (roughly equal risk exposure to multiple risk premia) and hedge funds over this period, two things that we know were good over this time frame, in the ex post optimal amount. Full period compound returns go way up, the financial crisis is far less damaging, the worst drawdown is not as severe and shorter (happening during the GFC but lasting only 9 months), and only 2013 was a (relative not absolute) loser versus 60/40 and prior combinations we have looked at (as both risk parity famously had a tough year, and hedge funds underperformed stocks).

By-the-way, if instead of over the full period we optimize the same way but maximizing compound return over the last 10 years, the period correctly seen as not quite as good for hedge funds as

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