The dollar hedge is used throughout finance, and it is a bad idea.
To see why dollar hedges are used so widely, look into the reasons that people use them in the first place.
An uninformed investor might decide to invest in a stock because they want to invest in the stock, and partly because they have an understanding that the equity market as a whole should increase in value, and so they are quite happy to have exposure to both stock and market.
As the investor’s portfolio widens to more stocks, the market exposure adds up steadily, whereas the exposure to individual stocks tends to be diluted by diversification: If you have 1000 bets on 1000 stocks, the chances of losing money because they all happen to be under-performing stocks is small, but the chance of losing money because you’re long on all of them and the market crashes is very high. So if the aim is not to get market exposure, the investor can limit their risk by taking an opposing position in something like an index future or ETF. This is particularly important if there is a net long or short bias in their stock-positions.
It seems intuitive that if the investor has $1 M long in equities, then they should have roughly $1 M short in the index future. After all, the market future is meant to represent the market as a whole. But there is a problem: This almost always over hedges. This can be explained in terms of the average beta of your portfolio.
The beta of a stock to an index is how much you expect it to respond to movements in that index. A beta of 100% means that if the index goes up 5%, then the stock will also go up by 5% on average. A beta of 50% to an index going up 5% would mean only 2.5% expected rise in that stock. On average the beta should be 100% – but *only* if the stock is one of the index constituents. In fact, the most traded indices (or futures / ETFs on those indices) have quite a small list of constituents (for instance the FTSE 100 or Eurostoxx 50), and if you’re trading outside that small list (which you typically will), the average beta does *not* have to be equal to 100%, and in fact is normally lower.
OTAS Technologies makes extensive use of in-house risk models. We noticed this effect when we found that the average beta for a range of sensible portfolios was significantly less than 100% to the Eurostoxx 50. We spent some time fixing things, putting checks in place, and analysing our smoothing and data cleaning processes. Useful though that was, ultimately the effect was real.
We suspect that the effect is partly due to simple maths: different things drive different stocks, and a random stock outside the FTSE 100 will not necessarily be pushed around by the same thing as the FTSE 100. Then there’s a capitalization bias: These indices focus on large cap names, whereas the average portfolio might not. Then there’s also the possibility that the market indices drive themselves: Because they’re considered to be a proxy for the market, they get traded by people who take large macro views, and perhaps that causes their constituents to behave subtly differently to the average stock.
The effect on the average portfolio manager of getting this wrong can be stark. The beta hedge is guaranteed (if the beta is calculated correctly) to reduce the risk of the portfolio, but the dollar-neutral hedge is not. We have seen extremely plausible portfolios where in fact the dollar-neutral hedge *increases* risk by even more than the beta-neutral hedge decreases it. The most important effect, though, is for portfolio managers who tend to have long ideas and so end up with a short hedge. If they pick a dollar-neutral hedge, they will have an overall short exposure to the market. This will increase their risk, and get them negative drift (assuming that the market has a slight long-term upward drift). This is frequently the cause of the complaint that “We had good positions today, but the market went up and we lost money overall on the hedge”. It’s certainly the case that a well-hedged book can lose money if the market goes up. But on average, if the portfolio is well balanced, using beta- not dollar-neutral hedging, the portfolio will not normally have down days simply because the market went up.
To summarise, there’s good news and there’s bad news. The good news is that you don’t need to hedge as much as dollar-neutral. The bad news is that you might currently be short.
In part 2, coming soon, we’ll hopefully look at some specific examples of when the dollar hedge has messed up a portfolio’s risk profile and performance.
Underlying data courtesy of Stoxx. The Stoxx indices are the intellectual property (including registered trademarks) of STOXX Limited, Zurich, Switzerland and/or its licensors (“Licensors”), which is used under license. None of the products based on those Indices are sponsored, endorsed, sold or promoted by STOXX and its Licensors and neither of the Licensors shall have any liability with respect thereto.