Choosing between correlation diversification and option hedges

As we enter a period of higher market uncertainty, there is increased demand for tail risk control for the simple reason the likelihood of a tail event increases. While portfolio diversification is critical and the best first line defense, there are other more focused ways to protect from these tail risks events. 

Diversification is the best approach if an investor does not have a view about the direction of markets. It is the agnostic hedge. At the other extreme is a clear view of direction which will require asset rebalancing conditional on the view. The problem is that most investors live in a world of maybe. Equities may go down and I may be leaning in that direction but my odds for a decline are not strong, and I cannot handicap the strength of the adjustment. We live in a world between diversification based on not having a view and a strong view that generates clear allocation biases.

The same problem also applies to downside protection. Investors can have a diversification tilt or hedge with an instrument that has focused protection. These downside choices can be classified as either correlation hedges or structural hedges. 

Correlation hedges offer protection because of their statistical properties across assets. Call it extreme or targeted diversification. The correlation hedge may be an investment uncorrelated with equities or even better, a negative correlation during a down event. In the simplest case, it has been holding bonds. For hedge fund investing, it could be trend-following.

A structural hedge is one that offers a different return stream because of their specific pay-off rules; an option trade. The structural hedge over time may differ from the ultimate pay-off, but at the terminal date of the hedge there will be a clear formulaic answer to the hedge cost and return.

The advantage of a correlation hedge is that the cost may be lower than an option trade. For example, holding bonds that may be negative correlated with stocks can protect a portfolio and provide a positive return although that value has diminished under the current low-rate environment. The disadvantage is that you may not get the historic correlation desired. You are betting on the past repeating.  

An option trade will cost the premium paid to gain the protection which will be associated with the strike chosen. That premium will change with volatility and the likelihood of the strike being in the money at expiration. You must get the strike right to match the size of the move. Protecting against a 5+% move is greater than the cost of a 20+% move. The out-of-the-money strike is cheaper, but investors don't get protection for a 10% down move.

Protecting against downside risk is timed closely with having a view - a view of cross market relationships and the magnitude of any downside event. Forecasting cannot be avoided.