This is a short and completely non-technical post that outlines our view on how to hedge a portfolio.
Our view is very simple and has 5 parts to it:
- A portfolio manager takes 2 kinds of risk: stock risk, which is when your stocks go down for their own reasons, and factor risk, when you might lose money because the market crashes.
- Stock risk is minimized by having a well diversified portfolio with not too much weight in any one stock.
- A lot of the factor risk can be eliminated by hedging the market using an ETF or index future.
- If you don’t have access to a risk-management utility, then we’d recommend hedging about 70% of your net position. For example, a $75M long amd $25M short portfolio would be hedged with roughly $35M short in a market future.
- Do not be tempted to completely net out your position: $75M long, $25M short, with a $50M short hedge in a market index is not a good idea at all (unless your position is entirely large-cap names that are actually consituents of the index). If you dollar-neutral hedge, you’ll probably lose money if the stock market goes up because your stocks won’t go up as much as the market does.
We have checked that this rule holds both when the market is calm and during crashes. There is some variation in the ideal way to hedge from year to year, but it’s not true that during a crash you should make sure you’re dollar neutral.
The value of 70% comes from lots of what-if analysis and beta calculations, and seems pretty robust. It does vary slightly depending on what’s in your portfolio, the investment time, and what you’re using to hedge, but as a rule of thumb, it appears to work well in a lot of situations.
This summarises the general view that OTAS Technologies has toward hedging.