Modern portfolio theory states that risk and return are linked, but today's financial experts can make the case that this link is not as direct and firm as the theory would make one believe. There are ways in which an investor can reduce risk and maintain high returns. Typically, investors change the risk-return profile by using hedging strategies. A portfolio that is unprotected from risk can have unlimited returns but is also subject to losses that can zero out the value of the portfolio. Protected portfolios limit the amount of loss.
Hedging is a way of mitigating both the alpha and beta risks associated with volatility. At its most basic, hedging uses two financial instruments that are equally, but negatively, correlated. For example, if Mary is concerned that Big Systems Inc.'s stock is going to go down in price, the investment manager would find a stock that historically goes up by the same amount when Big System's Inc. stock price decreases. This would be accomplished by calculating the return coefficients for various securities pairs and finding the pair that matches. Negative correlation securities pairs can be identified by looking at the correlation of movements between sectors. A negative correlation shows that one sector's market will historically rise as the other sector's market falls. For instance, if we look at the overall economy, and if the economy is slowly running into, or in the midst, of a recession, an investor will want to hedge into industries that consumers cannot live without. For example, utilities such as water and electricity are needed regardless of the economic cycle an economy is in and such companies can be used as a hedge in a portfolio.
However, if specific industries are looked at, it can be correlated that healthcare and fitness companies are a hedging pair. For example, if a hospital’s share price starts to fall, then consumers may be more inclined to take matters into their own hands and spend more time at gyms to alleviate health issues which increases share prices of fitness companies due to increased membership, dues, revenues, and ultimately share price. Thus, from this example there is a correlation hedge that can be utilized to help minimize risk and optimize returns.
These securities pairs are not easy to come by, so investment managers employ a more sophisticated technique using a derivative. A derivative is a contract allowing for the transfer of an underlying asset without actually transferring the asset. As an extreme example, an investor may have a large quantity of gold. Directly trading the precious metal comes with both fees and risks. The gold may be stolen or lost, and thus the investor needs security and transportation for the asset, which costs money and comes with substantial risk. To reduce the risk, the investor buys a contract to purchase the gold without ever taking possession of the gold. The contract is a derivative, and the gold is the underlying asset.A common hedging derivative is an option. An option is a form of derivative investment that allows, but does not obligate, the purchase or sale of an asset. Mary has a portfolio of shares in various clothing manufacturers. In the long run, Mary believes clothing will do well but is concerned with volatility in women's apparel. She sells the option to sell women's apparel stock if it falls to a certain price, called the strike price. This way, if the stock falls below the strike price, Mary only loses money to that point. She also makes money on the option itself.