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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 costs.

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 to scream.

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 bear markets.

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.

Source: Destroy The Investment Management Industry With Hedged Convexity Capture