Yesterday, we explored
Hedged Convexity Capture
, a strategy which captures the negative convexity associated with
leveraged inverse ETPs in a hedged manner in order to minimize
drawdowns. Today, we will explore a variation of the strategy which
creates a return stream which is almost totally non-correlated to
the performance of the S&P 500.
In order to achieve this goal we will:
I. Short SPXU (
) with 40% of the dollar value of the portfolio.
II. Short TMV (
) with 60% of the dollar value of the portfolio.
III. Rebalance weekly to maintain the 40%/60% dollar value
weighting between the two instruments.
SPXU is a 3x leveraged inverse S&P 500 ETP. TMV is a 3x
leveraged inverse long bond ETP. Not only does shorting TMV
effectively provide a hedge for the short SPXU position, but the
effectiveness of the hedge is dramatically increased by the fact
that TMV itself suffers from negative convexity as well.
Here are the results of applying the strategy in a graph with a
(click to enlarge)
(click to enlarge)
Notably, the strategy only has a 0.11 correlation to the
performance of the S&P 500. Moreover, the strategy outperformed
the broad equity market over the entire period with a much higher
Sharpe and CAGR/Max Drawdown ratios. I would even argue that the
strategy probably has almost zero correlation to the S&P 500,
and that any seeming correlation is due to the fact that both the
performance of the strategy and the performance of the S&P 500
drift higher over the course of the entire period examined.
If we highlight the performance of the strategy during 2011, a
very choppy period for the S&P 500, we get the even less
correlated results below:
(click to enlarge)
Notably, while some may argue that a strategy which shorts
leveraged ETPs is inherently dangerous, the strategy is worth
exploring further. Non-correlated Hedged Convexity Capture
dramatically outperformed a choppy equity market in 2011. It had a
correlation of 0.02, a Sharpe of 2.35, and a CAGR/Max Drawdown that
is off the charts. The data shows that the strategy could be far
less risky than a passive investment in the S&P 500.
However, even though the strategy tests well, I never rely on
theory alone. The advanced non-public version of this strategy uses
a systematic switch to enter and to exit the strategy to further
The sweet spot for investors is non-correlation combined with a
superior CAGR/Max Drawdown ratio. That data points to the strong
possibility that Hedged Convexity Capture can achieve that goal and
is worthy of further refinement and, potentially, use.
This does not mean that the strategy's massive outperformance
will continue, but it does mean that the strategy is worth further
exploration. Investors are constantly bombarded with intuitive
strategies. And intuitive strategies may be excellent marketing
vehicles, but they are often far worse performers than
non-intuitive strategies. Strategies which rely upon an
understanding of pure mathematics have a higher probability of
sustained outperformance, because most people are not wired to feel
emotionally comfortable with mathematical strategies.
It is this emotional discomfort which not only hinders the
popular adoptions of such strategies, but also creates the
potential for sustained outperformance for those unique investors
who do appreciate their logic.
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.
W.W. Grainger Management Discusses Q3 2013 Results
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