Hedging the World: Assessing the Performance of Dynamically Hedged Long-Short Equity Investments

The extraordinary conditions in the financial world of late 2008 caused severe market dislocations and consequently many asset managers experienced sig-nificant portfolio losses, partly due to ineffective hedging techniques. In order to examine the effect of the credit crisis on investment strategies, we create a diverse set of long-short equity portfolios with domestic equity sectors and an array of MSCI indices by extending Engle (2008). Each domestic sector is hedged against the others and the S&P 500, while the MSCI indices are hedged against the MSCI World index and S&P 500 over 1/1/02 — 2/27/09. Hedge ratios determined via GARCH-DCC and TGARCH-DCC are used for daily portfolio reallocation. We find that hedging in this method generally results in a significant volatility reduction and thus a benefit to the investor. Further in-spection reveals that DCC may underestimate correlation during times of high volatility, a condition that is exacerbated for the international indices due to a non-synchronicity in information.