Diversification versus Hedging

SUMMARY

• Hedging and diversifying strategies have different objectives
• Downside betas can be used to differentiate these
• Alternative strategies have overtaken bonds as the most diversifying strategies

INTRODUCTION

In investing, some terms are used interchangeably, despite these having quite different technical interpretations. For example, most investors put stocks with strong sales growth, strong performance, or expensive valuations in the same “growth stock” bucket, but these companies often have significantly different characteristics, eg cheap stocks outperformed and acquired momentum features in the first quarter of 2023, but these companies do not exhibit strong sales growth.

The same applies to diversification and hedging strategies, which are often considered the same, but are not. Hedging refers to protecting a portfolio against a stock market crash, while diversification is about finding strategies that offer uncorrelated returns to equities.

In this article, we will contrast both strategies.

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