Written on 11 April 2013.
The publication, “Hedging versus Insurance: Long-Horizon Investing with Short-Term Constraints,” demonstrates that failing to separate long-term risk-aversion and short-term loss-aversion may lead to poor investment decisions. As an illustration, the research points to a 32% opportunity cost when managing maximum drawdown constraints inefficiently through an excessive level of hedging.
The authors of the study, Romain Deguest, Lionel Martellini and Vincent Milhau, draw two major conclusions from their work:
• Relatively simple solutions exist that can be implemented as dynamic asset allocation strategies in order to control short-term risk levels while maintaining access to long-term sources of performance.
• These solutions are a substantial improvement over traditional strategies without dynamic risk control, which inevitably lead to under-spending of investors' risk budgets in normal market conditions, with a strong associated opportunity cost, and over-spending of investors' risk budget in extreme market conditions.
BNPP IP has been working with EDHEC-Risk Institute in a partnership mode to bring EDHEC academic research closer to industry practices and issues. Contributing to academic research is key to designing innovative investment solutions taking into account its main conclusions and insights. BNPP IP has in particular developed a range of dynamic solutions for its institutional clients managing short term risk and long term expected returns in the spirit of this last EDHEC-Risk research paper.
A copy of “Hedging versus Insurance: Long-Horizon Investing with Short-Term Constraints” can be downloaded via the following link:
EDHEC Risk Publication Hedging vs Insurance: Long-Horizon Investing with Short-Term Constraints
This research was supported by BNP Paribas Investment Partners as part of the “Asset-Liability Management and Institutional Investment Management” research chair at EDHEC-Risk Institute.