Portfolio Hedging Strategies and Geometric Returns: From Theory to Practice

Arguments for and against portfolio hedging tend to be highly polarized, with conclusions often limited by the availability of historical data. In this article, the authors introduce a framework that takes a Monte Carlo simulation–based approach rather than relying on historical analysis and focuses purely on whether portfolio hedging can improve long-term compounded returns. Considering a hypothetical diversifying asset class with a nonlinear conditional return profile, they show how hedging can improve the geometric return of a portfolio even when the hedge has a lower expected return than the asset class it replaces in the portfolio. The authors quantify the characteristics required of a hedging asset class for it to improve the geometric portfolio return and compare theoretical results to what may be achievable in practice based on the performance of a range of different hedge fund portfolios targeting specific levels of downside equity beta.