We examine a broad variety of strategies intended to protect a fund of funds from downside risk, focusing on the protection provided by investing in particular types of hedge funds themselves as well as in overlays using commodities and credit or volatility derivatives.
We find that downside risk is not a single thing. Historically, different strategies have been helpful hedges at different times. Allocations to CTA or Macro hedge funds would have been effective during prolonged momentum-driven crises. Gold and oil investments have been of more occasional help. CDS trading would have been useful in crises involving sovereign and corporate default risk. Volatility overlays generally provide the most generic downside protection, because rising market volatility is often a hallmark of impending and realized crises, Unfortunately, the cost of continual volatility exposure is prohibitive unless you can hedge at the right time. We note that third-quartile (high but not enormous) VIX levels often foreshadow impending crises and that S&P puts bought during those periods have provided good statistical protection at low net cost.
We conclude that there is no panacea for hedging crises. To truly protect a portfolio against downside risk requires buying insurance against all its known manifold risks, plus other yet unimagined ones. Though tactical protection appropriate to the type of crisis can help, it requires timing, which is difficult. In practice, there is no substitute for careful due diligence, understanding specialist strategies and their strong and weak points, and skilled diversification that avoids concentration and risk and style overlap.
Can One Hedge the Tail Risk of a Fund of Funds_November 2011