Comparing Direct Put Hedges with Correlation-Based Portfolio Hedges

Summary

The document contrasts two ways institutional investors seek to reduce portfolio tail risk. A direct hedge buys puts on the asset that drives much of the portfolio’s risk, making the premium an explicit cost when protection is not needed. A correlation-based hedge allocates to strategies expected to behave differently from the main portfolio risk; its cost can appear as weaker relative performance when the core portfolio is doing well.

The question is how to compare these approaches while accounting for both protection and cost, and whether low correlation remains dependable in a crash, when correlations may rise sharply. The document presents the trade-offs and asks how managers evaluate alternatives, but supplies no proposed metric, empirical comparison, or answer. Any assessment would need to consider the portfolio’s objectives, hedge behavior in stressed conditions, and the opportunity cost of the allocation; the discussion alone does not establish which method is more effective.

Key ideas

• Buying puts can provide direct protection against losses in a portfolio’s main risk exposure.
• A direct hedge has an explicit premium cost when the protection is unused.
• A correlation-based hedge may have an opportunity cost when it lags the core portfolio.
• Low historical correlation may not provide reliable protection during market crashes.
• A useful comparison would account for both risk reduction and the costs of each approach.

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# Measure of hedge efficacy or other means to compare hedging strategies?


# Measure of hedge efficacy or other means to compare hedging strategies?












Is there a measure of hedge efficacy or another means to compare hedging strategies? I have seen Institutional Investors take very different approaches to tail hedging.

On one extreme, I have seen tail hedging programs that take a direct approach to hedging tail risk. These programs will entail buying puts on the underlying that comprises the majority of the risk in the portfolio. Obviously this has direct and knowable costs when the hedges are not needed.

At the other extreme, there are investment programs that utilize a hedging program that is basically a correlation hedge. The essence of these programs are that they are making an allocation to strategies with low correlation to the major risk in the portfolio. While there is no direct cost for these hedges when the are not needed, the costs would come in the form of reduced performance due to an asset allocation that may not be performing when the rest of the portfolio is working. Also, since the hedge is relying on low correlation to provide protection, does this approach work in major crashes when correlations go to 1?

Is there a measure of hedge efficacy that takes protection and all the costs into account when evaluation hedging approaches? How have investment managers evaluated/compared alternatives in the absence of such measures? It seems like one approach is a direct reduction of undesired risk, while the other relies on the luck that correlation is working at the moment one needs the protection.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.