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Risk management: More hedge funds are hedging

Many hedge funds are significantly more hedged that they were one year ago, says Steve Gross, principal of Penso Capital Markets, a New York asset management and risk management firm.

"Eighteen months ago, when the cost of hedging was historically cheap, nobody wanted to buy insurance. People forgot about risk and have now been brutally reminded," says Gross, whose risk management capabilities have been attracting an increasing number of new clients. He says that, counterintuitively, it is the hedge funds that are expecting to make huge returns from opportunities in present market conditions that should be hedging more. "The more bullish you are, the more it makes sense to give away a little of the upside to hedge in case you are wrong," he says. "Conservative managers, by contrast, have constructed their portfolios with the expectation of further risks, and therefore the hedge is less necessary."

Just how big can the downside be? If a regular recession/bear market unfolds, Penso expects the bottom to be when the market has dropped 25% to 30% from the highs and PE ratios hit 13 to 14. That would be 1100 to 1150 on the S&P. If, however, inflation does not abate, a recession persists, and the US enters into stagflation, the S&P could drop to 1000 or lower.

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