Experienced fund managers, particularly those managing mutual funds, employ a variety of risk management strategies honed over years of experience. One such strategy is dynamic hedging, which helps mitigate the risks associated with adverse price movements. In volatile market conditions, dynamic hedging enables fund managers to adjust their long and short positions in response to real-time signals. This flexibility allows them to protect portfolios from sharp declines in asset prices, effectively safeguarding investors’ capital.
A notable case study highlighting the effectiveness of dynamic hedging is found in a trend-following strategy discussed in the “Journal of Portfolio Management.” Led by Brian Hurst, Yao Hua Ooi, and Lasse Heje Pedersen, the study analysed over 137 years of data (1880–2016) across 67 global markets, covering major asset classes such as equities, bonds, commodities, and currencies. The study’s findings were striking, particularly in market downturns. In the ten largest drawdowns of a traditional 60/40 stock-bond portfolio, trend-following strategies posted positive returns in 8 out of 10 cases, including during periods of severe economic stress like the Great Depression and the Global Financial Crisis (2007–2009). These results underscore the effectiveness of dynamic hedging in providing downside protection even when broader markets face deep losses.
Moreover, this trend-following strategy demonstrated resilience not only during financial crises but also across extreme macroeconomic environments, including periods of war and high inflation. The strategy performed well during major global conflicts, such as World War I, World War II, and the Vietnam War, as well as in high-inflation periods. Its ability to adapt to both rising and falling markets makes it a versatile tool, offering protection during bear markets while capturing gains during bull markets. By going long in upward-trending markets and adjusting positions dynamically, the strategy ensures steady performance across all market phases, not just during downturns.
Futures and options play a crucial role in implementing dynamic hedging strategies, allowing fund managers to hedge portfolios and manage risks effectively in volatile environments. One significant advantage of dynamic hedging is its ability to generate alpha. By allowing investors to maintain their positions without fully exiting stocks, thereby avoiding taxes and transaction costs, dynamic hedging offers a cost-effective approach to risk management. This strategy provides downside protection while allowing investors to re-enter the market when conditions improve, all without needing to time the market perfectly. In doing so, dynamic hedging enhances alpha generation and improves the Sharpe ratio, a key measure of risk-adjusted returns. Overall, dynamic hedging is a strategic and efficient method for managing risk while maximizing returns for investors.
(The author is Chief Investment Officer (CIO), SAMCO Mutual Fund. Views are own)
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