Benefiting from Simple Hedging Techniques (Part II)

In the previous article, we discussed a simple hedging technique which always fully or partially hedges a portfolio. In this part, we will discuss two more effective ways to hedge.

A natural way to improve hedging technique is to use timing indicators as the guide to hedge or unhedge. Moving averages are one of the simple and effective indicators. Using moving averages, one could start to short the chosen index ETF(s) when the indicator gives a sell signal and then buy back the ETF when the indicator gives a buy signal. ValidFi's Momentum Hedge is a very good example to show that by using such a simple technique, one could achieve a reasonably good return while reducing the risk dramatically. In this strategy, a portfolio based on Sector Rotation Fidelity Select Funds strategy is used as the long portion of the portfolio while short position on SPY is taken based on whether SPY price is lower than its 130 days EMA (Exponential Moving Average) or its 200 days SMA (Simple Moving Average). The following table is the comparison of the long only portfolio and the hedged portfolio using 130 days EMA up to 9/1/2009.

		Last 1 Year (%)	Last 3 Year (%)	Last 5 Year(%)	Since 12/31/1993 (%)
Annual Return	Long Only	-11.83	-0.51	11.62	16.01
	Hedged	27.6	8.6	15.4	13.8
Sharpe Ratio	Long Only	-32.3	-7.6	35.69	55.07
	Hedged	120.5	32.1	62.7	51.3
Standard Deviation	Long Only	37.2	29	27	24.7
	Hedged	22.7	21.3	21.4	22.1
Maximum Drawdown	Long Only	34.9	47.5	47.5	51.1
	Hedged	13.9	20	20.4	49.6

Notice that maximum drawdown for the hedged portfolio improved in the last 1, 3 and 5 years but it has a huge 49.6% maximum drawdown since the inception date. This occurred during 2000-2001 period. This offers a cautious tale to hedge against a momentum driven portfolio: there might be still a period of time where mismatched performances between the long and the short portions of the portfolio could be way too high to be tolerated.

Yet another way to hedge is to always short so called weak assets (or sectors) with a corresponding or a lesser amount. When shorting with equal amount as the long portion's, this is often called zero cost hedge as in theory (and for large institutions), the brokers would use the borrowed amount from the short sale to offset the long amount used. In ValidFi's Global Tactical Asset Allocation Momentum strategy, based on the original paper, 100% short amount is used to short the worst performing three assets based on their past price performance while in the meantime keeping a long portfolio on the best performing three assets. For example, at the moment, the long part of the portfolio consists of VUSTX, GLD, VWEHX and the short part of the portfolio consists of VGSIX, VIMSX and VGTSX. Notice in this portfolio, we use index funds as the shorted indexes. In practice, one should substitute the above using ETFs equivalent. That would translate into long TLT, GLD, HYG and short IYR, MDY and EFA. The result is a mixed bag as one could see from here.

It should be further noted that aside from the hedging, one could always perform tactical asset allocation (such as reducing or increasing the risky asset exposure) to avoid taking short positions. It is a simpler solution. The main reason to hedge instead of reducing the risky asset exposure by selling has to be that one believes the long portfolio could outperform the shorted index(es) during the possible market downturn. If this does not hold or it is hard to justify such an out performance, reducing or liquidating the positions is a better choice. The pros and cons should be weighed carefully.

One notable mutual fund which performs long and hedging is Hussman Strategy Growth Fund (HSGFX) managed by John Hussman. For anyone who is interested in the hedging techniques and Dr. Hussman's view points on current economic and market conditions, his weekly comments offer very educational and prescient information.

In conclusion, some simple hedging techniques could go a long way to protect your capital while enhancing returns. In the current economic conditions, it is worthwhile to pay attention to them.

Disclosure: No positions