Since the market bottom in March 2009, stocks have risen a little over 200% and volatility has been relatively muted. But looking ahead, we expect equity returns to moderate and volatility levels to rise. As a result, investors may want to think about hedging strategies to mitigate their downside risks, maintain their equity allocations in a risk-controlled way and bounce back from downturns more quickly. We believe that investors need to consider the following three traits in their hedging strategies:
Your hedge needs to work—not some, or most, of the time—but all of the time.
A key assumption behind diversifying across asset classes is that correlations remain constant over any one investment horizon. The idea is that over a long period of time, stocks and bonds won’t move up or down at the same time, or at least by the same degree, which can smooth out returns, hedge portfolios against big losses on single investments and position investors to benefit if one corner of the market posts outsized gains.
But depending on market and volatility regimes, correlations can vary. Exhibit 1 shows the relationship between fixed income and equities and the correlation between the two. Since January 2004, the average correlation between the is -0.09, but it has ranged between a minimum of -0.61 and a maximum of 0.64.
Recent correlations between stocks and bonds have become more positive
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