How to Answer “How would you hedge a concentrated long position?” in Hedge Funds Interviews

Start by stating what “hedge” means for this situation: are you trying to (a) reduce mark-to-market volatility, (b) cap downside drawdown, (c) protect a specific catalyst window (earnings/regulatory), or (d) neutralise systematic exposures while keeping stock-specific upside? This framing is the difference between “I’d buy puts” and a credible hedge plan.

Next, set assumptions and constraints the way you would on a desk: size vs NAV and risk limits, time horizon, liquidity (can you exit the underlying quickly?), ability to short single names, ability to use futures/options, and whether the fund manages net exposure targets. Mention practical frictions early: borrow availability/recall risk for shorts, option liquidity and tenor, and whether you’re allowed to run “temporary” hedges around events.

End this step with a measurable target (even approximate): e.g., “reduce market beta contribution by ~70%” or “limit 1-month downside to ~X% under a gap scenario.”

Explain how you’d diagnose what needs hedging before choosing instruments. Decompose the position into:

1. Market/sector beta: sensitivity to broad indices (e.g., SPX) and the relevant sector index.
2. Style/factor exposures: growth vs value, size, momentum, quality, rates/duration sensitivity, commodity inputs, FX, etc.
3. Idiosyncratic/event risk: earnings gaps, regulatory decisions, litigation headlines, deal breaks—risks that don’t track the index.

In practice, you can cite a quick regression on daily/weekly returns, a factor risk model, and a few simple stress scenarios. Call out the concentrated-position reality: correlations can jump in risk-off, liquidity can deteriorate, and single-name gap risk can dominate, so “just short the index” often leaves a large residual.

The goal is to identify the biggest systematic driver first (often beta/sector), then decide if you need a more tailored hedge to reduce basis risk.

Lay out a small menu of hedging techniques, but tie each directly to the risk you identified:

• Index or sector futures/ETFs: best for fast, liquid beta reduction; you accept tracking/basis risk versus the single name.
• Factor or basket hedges: short a sector basket or factor proxy aligned to the position’s exposures (useful when the name behaves like a factor expression, e.g., high-duration growth).
• Peer short / pair trade: best when you want to isolate company-specific alpha and minimise basis risk; requires borrow availability and a clear relative thesis.
• Options trading structures: protective puts, put spreads, collars, or overwriting calls; best for event/tail protection and defined downside, but you pay premium and face implied-vol dynamics.

Show judgment consistent with investment strategies for hedge funds: use the simplest, most liquid hedge to remove the largest risk first, and add complexity only when it buys you meaningful downside protection or better alignment.

Explain sizing in a way you could do on a whiteboard.

For a linear beta hedge: estimate the position’s beta to the chosen hedge (market or sector), then set hedge notional to reach your target beta. A simple approach is: hedge notional ≈ position $ exposure × beta × desired % reduction.

For a peer/basket hedge: size by matching the key exposures you’re trying to neutralise (sector weights, factor loadings) and sanity-check with scenario P&L.

For options: size by delta (and acknowledge gamma/vega) and match expiry to the risk window (earnings date, regulatory decision). Discuss trade-offs explicitly: option premium and implied vol (hedge “bleed”), futures roll/carry, borrow costs and recall risk, and tracking error from imperfect hedges.

Close with decision discipline: define what would make you increase, reduce, or remove the hedge (vol regime change, thesis milestones, position no longer concentrated due to price moves, catalyst passes).

Finish with how you would run it day-to-day, which is central to risk management in hedge funds. Track hedge effectiveness via P&L attribution (how much of the move was market vs idiosyncratic), beta drift, and changes in correlation—especially during stress.

Address basis risk head-on: if the stock sells off on idiosyncratic news while the index is flat, an index short won’t protect you. Your choices are to accept that residual risk, pivot to a tighter peer/basket hedge, or add event/tail protection with options.

Also mention mechanics that matter for concentrated positions: rebalance after large moves (delta drift for options; exposure drift for linear hedges), avoid hedges that introduce unintended factor bets, and have a clear unwind plan so you’re not paying for protection after the catalyst window or risk regime changes.