Diversification versus Hedging

Same, same, but different?

June 2023. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Hedging and diversifying strategies have different objectives
  • Downside betas can be used to differentiate these
  • Alternative strategies have overtaken bonds as the most diversifying strategies

INTRODUCTION

In investing, some terms are used interchangeably, despite these having quite different technical interpretations. For example, most investors put stocks with strong sales growth, strong performance, or expensive valuations in the same “growth stock” bucket, but these companies often have significantly different characteristics, eg cheap stocks outperformed and acquired momentum features in the first quarter of 2023, but these companies do not exhibit strong sales growth.

The same applies to diversification and hedging strategies, which are often considered the same, but are not. Hedging refers to protecting a portfolio against a stock market crash, while diversification is about finding strategies that offer uncorrelated returns to equities.

In this article, we will contrast both strategies.

CREATING A HEDGING / DIVERSIFICATION STRATEGY

We select mutual funds and ETFs with the most promising diversification potential, which we define as the product of the downside beta to the S&P 500 and the total return over the last five years. Funds with positive downside betas are excluded. Stated differently, we are looking for funds that generate positive returns when stocks decline, but that have the ability to make money (read Downside Betas vs Downside Correlations).

We create a portfolio of such funds by selecting the top 10 funds with the most negative scores (“Downside S&P 500 Portfolio”), which is held for a year and then rebalanced. We observe that the performance of the Downside S&P 500 Portfolio was negative over the period from 2005 to 2023, although most of the negative performance can be attributed to the last two years. More interesting is that the strategy did generate attractive diversification benefits when the stock market crashed or declined, eg during the GFC in 2008 or the COVID-19 crisis in 2020.