Our macro view is that unique intellectual property, based upon
science rather than artistry, will drive investment performance in
the future. In addition, high quality rules-based strategy indices,
marketed through strategy-based ETFs and mutual funds will eclipse
hedge funds due to their transparency, liquidity, and low
What will occur is a disintermediation between the creators of
high quality systematic investment strategies and traditionally
vertically integrated distribution channels. Self-directed
investors will be able to find a variety of transparent,
systematic, rules-based, high performance ETF and mutual fund
alternatives to traditional high-fee hedge funds. Once the
performance and capacity of strategy-based ETFs and mutual funds
reaches a tipping point, hedge fund fees and AUM will dramatically
drop. In addition, in a vicious cycle, this new competition,
seeding increasingly sophisticated investment models with
ever-larger AUMs, will lower hedge fund returns, further pressuring
fees in the liquid alternatives space.
And there will be a mad rush by ETF and mutual fund firms with
the distribution, size, and scale to introduce strategies which can
produce Sharpe ratios of 1.0 and above, and MAR ratios of 2 and
above. Serious research, insight, and discipline will again rule
the day. That's our macro view of the investment management
industry, and we have been positioning to make it a reality by
creating a myriad of innovative strategy-based indices, which we
are working to license.
Today, let's examine one simple strategy which we have created,
stripped of its advanced bells and whistles which we will not
publicly disclose at this time. The point of sharing a primitive
version of this strategy is to prove that the future will be won by
elegantly powerful mathematical insights that are expressed
efficiently and in a package that retail investors and pension
funds alike can effectively use.
What do I mean by this? For all of the arrogance of the
alternative asset management industry and its pretensions of
modernity, it really is like the computer industry of 1980,
manufacturing expensive, unwieldy, opaque, primitive mainframe
computers which are prone to breakdowns. The unstated, yet
desperate need of investors everywhere is something which is
powerful, simple, elegant, radically transparent, and cheap, like
the first Apple computers, or the early PCs. I believe that we are
on the cusp of such a revolution, which will free investors from
monthly liquidity restrictions, gates, opaque structures, high
fees, and undisclosed risks.
Today's example (stripped of its bells and whistles) is Hedged
Convexity Capture. The idea behind Hedged Convexity Capture is to
benefit from the path dependent negative convexity that has been
widely observed in leveraged ETP products in an efficient
risk/reward method which dramatically lowers the potentially
ruinous drawdowns of shorting leveraged inverse ETP products. Quite
simply, we are pairing a 50% dollar short position in the leveraged
inverse [[TZA]] with a 50% dollar short position in the leveraged
inverse [[TMV]] and rebalancing the dollar amounts each week.
Remember, a short position in the TZA is synthetically going long
small cap indices, while a short position in the TMV is
synthetically going long 20+ year government bonds. The short TMV
position is partially hedging the short TZA position, so there is
still a long bias in the portfolio.
However, there are crucial differences and advantages to merely
being in a leveraged long equity position. Due to the leveraged
nature of these ETPs which resets daily, we are not merely
capturing the performance of a long small cap index position paired
with a 20+ year government bond position. By shorting these
leveraged ETPs, we are benefiting from the highly probable path
dependent negative convexity associated with these instruments.
This means that we capture return, not only from rising equity
markets, but also from the strategy when the equity and bond
markets move sideways, due to the path dependent negative convexity
of the component ETP instruments created by their daily leverage
resets. So rising bond and equity markets help the strategy, as do
sideways-moving bond and equity markets.
And this is profound, because unlike conventional factor based
equity quant market neutral strategies which are dollar neutral
while being exposed to factors such as quality, growth, and
valuation, we are gaining exposure to a factor--path dependent
negative convexity--which is not as widely harvested in the
investment world, and is therefore much more profitable to target
and to capture.
In other words, there are a variety of well-known factors which
are old, well-worked over, tired, and commoditized which are
favored by most investment industry pseudo-intellectuals.
Therefore, these factors no longer earn outsized returns. By
targeting a less well known and understood factor which is purely
mathematical in nature (path dependent negative convexity anyone?),
as opposed to intuitive factors which are well known to equity
fundamental practitioners, or would-be economists mired in the well
picked over risk-parity morass, we can achieve outsized returns.
Note to the kind reader, if I have to read one more uninspired
best-seller or "thought piece" about squeezing an additional 1%-3%
from traditional value strategies or from risk-parity, I am going
So how does a strategy which allocates 50% of the portfolio to
shorting TZA and allocates 50% of the portfolio to shorting TMV,
while rebalancing once weekly, perform?
Due to the starting dates of the ETPs, the backtest starts from
April 16, 2009, but even with the limited data available, an
important pattern is emerging.
The CAGR of the strategy, divided by the max drawdown, exceeds
2, while the CAGR of the S&P 500 over the same period divided
by its max drawdown is less than 1, meaning that the S&P's
drawdown exceeded its CAGR. And of course, the Sharpe ratio of the
Hedged Convexity Capture strategy is superior. I can hear the
cacophony, of voices now, "Oh, but your backtest is only from early
2009!". But consider the inverse position. If one does not think
that capturing negative convexity makes statistical sense, would
one feel comfortable fading a strategy which has beat the S&P
500's performance by over 30% per year since inception with a much
better return to risk profile and a 0.61 correlation? I think not.
However, I would counsel caution. The private version of this
strategy with all its associated bells and whistles has far more
safety mechanisms built into it than simply shorting and
rebalancing two instruments in a 50/50 dollar proportion and hoping
for untold riches. Theory is fine for theorists, but I always
demand a plan of action if theory doesn't hold, which is built into
the system itself to turn it off when it is unprofitable or unduly
risky to run.
The purpose of this example is to give the gentle reader a taste
of what is possible with even simple statistical methods, which far
exceed the performance even the most able conventional
discretionary management. Using other rules, instruments, and
proportions more complicated than a simple 50/50 split default can
yield historically far less correlated performance to wider equity
indices. But even in this simplistic form, we can reasonably
extrapolate that the system outperforms the S&P 500, even in
Although it is outside the scope of this article, one can model
the performance of leveraged ETPs that hold swaps to verify or
disprove such an assertion. But the bigger picture is that unique
intellectual property, based upon science, rather than artistry,
will drive investment performance in the future. And creating
transparent, rules based strategies will allow investors to take
far more control of what risks they decide to take on, since they
will have the opportunity to evaluate a strategy's reasonableness
for themselves, by removing the black boxes that previously
shielded rules from public view, consideration, or censure.
In the final calculus, the investment industry will move to a
more pure form of competition which resembles the marketplace of
ideas. And the best ideas can be considered, evaluated, monitored,
and chosen or discarded once they are made transparent to all.
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it (other than from Seeking Alpha). I
have no business relationship with any company whose stock is
mentioned in this article.
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