Hedging vs. Diversification : Comparing the Cost of Hedging to the Cost of Diversification

Given a low-interest-rate environment, the authors examine whether holding debt is still an optimal asset allocation in a portfolio framework compared with using a negative carry protective-put strategy. The basic premise is to examine utilizing direct equity hedges in a portfolio and compare the cost of these hedges with the potential cost of bonds as interest rates have set near multi-decade lows. The protective-put strategy is presented as an alternative to debt in a portfolio framework. This paper examines the performance of a portfolio that is more heavily weighted toward equity than a traditional portfolio and uses a small amount of the portfolio to directly hedge the equity exposure. The performance is compared with that of a 60-percent equity/40-percent bond portfolio. The paper also examines how adding a reliably negatively correlated asset to a portfolio can enhance risk-adjusted returns via a systematic rebalancing approach. The strong performance of the hedged equity approach, specifically since 2017, is attributable to the large presence of option sellers in the market. The authors find that the performance of the hedged equity portfolio is competitive with that of a traditional 60/40 portfolio