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Hedging for 13 Basis Points

Apr 24, 2012 Will Clemens

A hedge fund is commonly defined today as "an aggressively managed portfolio of investments that uses advanced investment strategies", according to Investopedia. But before this general definition took hold, hedge funds, or "hedged funds", were vehicles that focused on hedging, or providing some protection and diversification when markets went down or otherwise didn't perform as planned. Back in 1966, Fortune profiled the man widely considered the father of the modern hedge fund, Alfred W,. Jones, and in that article defined hedging as being in a position to make money in rising and falling markets, and also to be "sheltered" if the direction of the market has been misjudged. In contrast to today's definition, Alfred Jones and other original practitioners might have emphasized the fundamentally conservative, not aggressive, nature of their investment vehicles. This original definition seems pretty good!

Fast-forward to today. In the aftermath of the 2008 crisis, one of the most painful lessons we learned was supposedly uncorrelated investments can lurch towards high correlations at the worst possible time.

As the chart above shows, all major asset classes, including supposed diversifiers like TIPS and commodities (the GSCI index), leapt from negative to positive correlations very quickly during the crisis, and have remained positively correlated. It's also notable that the major equity classes were so positively correlated that arguably they provided no diversification benefit.

So, how can an investor find true diversification? Of course, certain classes of hedge funds or inverse index products can provide some.

As shown above, the Hedgefund.net market neutral index generally marched along at around .5 correlation, and even declined in correlation during the crisis, and the short bias index had almost a perfect inverse correlation. However, .5 correlation might not be good enough, and performance and fees for a short bias fund might not suit all investors.

So, correlations are high, and the cost of true hedging seems to be high fees and maybe disappointing long term performance? Are we all doomed to the vagaries of the market?

Is there an investable index that provides legitmate diversification at reasonable cost? Perhaps. In 2007, Vanguard introduced the Extended Duration Treasury ETF, designed for long term liability matching of pension funds. This ETF very closely matches the Citi 25 year Treasury Strips index (99%+ R-squared), and is available for 13 basis points. As the chart below illustrates, the Citi index provides solid negative correlation, with only a slip above zero briefly during the crisis but otherwise solidly below zero throughout the 1997-2012 life of the index.

More interestingly, this index and product have had staggeringly positive performance during the "flight to quality" of the last year. Of course, this performance won't be repeated, and even with an SEC yield of above 3.25%, this index has a duration above 25 and will be clobbered when interest rates rise. However, as the Short Bias index showed, all asset classes will be hurt when their markets move against them. The point is to piece together a collection of asset classes that move in different directions throughout cycles. 2008 showed us that it's much harder to build truly diversified portfolios than we may have believed. But the pieces are out there if you look. And of course, this index's correlations could change. But sometimes, true diversification is trading right there on the exchanges, yours for 13 basis points.

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