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Hedged Convexity Capture III

By: SeekingAlpha
Posted: 9/10/2013 6:05:00 AM
Referenced Stocks: SPXU;TMV
By Harry Long :

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 ( SPXU ) with 40% of the dollar value of the portfolio.

II. Short TMV ( 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 log scale:

(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 reduce risk.

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.

Disclosure: 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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