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

The extraordinary conditions in the financial world of late 2008 caused severe market dislocations and consequently many asset managers experienced significant 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 inspection 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. 1 The author would like to thank the Stern School of Business at New York University for its support in this research endeavor. In particular, I would like to thank Marti Subrahmanyam, coordinator of the Honors Program, Robert Engle, my thesis advisor, and Christian Brownlees of the Finance Department at the NYU Stern School of Business for their invaluable contributions. The author’s e-mail address is [email protected]. Any remaining errors are the sole responsibility of the author.