hi there,
just a quick question. I’m reading the curriculum about the hedged portfolio approach and I find the name of this strategy a bit misleading because I am not exactly sure what we are hedging?
I thought the strategy was used just to identify which factors lead to higher returns
Hey there.
I believe you are referring here to a Hedge/return seeking approach to asset allocation.
Its a two step allocation LDI approach that assumes you have a portfolio surplus (A>L). In first step you take a conservative position to hedge the liabilities (this is of outmost importance if you are a conservative investor and want to be sure you are covered for liabilities cash outflows) and in second step you take a more aggresive allocation approach to invest the surplus of portfolio an earn a bit higher E(r).
There, now you have hedged your liabilities and invested surplus in riskier allocation to earn higher rate of return.
I think its straightforward.
no it wasnt about asset allocation reading. Its in equity
Ahh… ok, you are referring to long/short hedged portfolio.
So, first thing you do is choose to which equity factors you want to be exposed (RMRF, SMB, HML or WML). Then, when you have carefully chosen these factors, you see which stocks chosen perform best according to factors chose and which perform the worst. How you do that? You usually divide them in quantiles (from best to worst performing). In order to provide “best result” you want to buy top 10% or top 20% (usual convention) of best performing stocks (as you expect they will continue to perform well) and short 10% or 20% of worse performing stocks (as you expect them to continue to poorly perform). This way you would “hedge” yourself from poor returns, as you can can benefit from both, long and short positions - long positions gain in value when perform well, short positions perform well when performing poor.
However, there are couple of drawbacks which are explained further in the curriculum (e.g. shorting expensive or not possible, risk factor overlap or ignoring the information fror mid quantiles not taken in consideration).
thanks toto