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Last week, we explored Hedged Convexity Capture, a strategy which seeks to capture the negative convexity associated with leveraged ETFs. The idea behind Hedged Convexity Capture is to capture the potential returns from shorting leveraged inverse equity ETPs with lower drawdowns than by just shorting them outright. The strategy seeks to accomplish this by shorting leveraged inverse ETPs and pairing that short with a short position in TMV, an inverse leveraged long bond ETP.

Not only does shorting TMV often provide a hedge for the equity portion of the strategy, but TMV itself suffers from negative convexity, further increasing the effectiveness of the hedge.

Last week, we explored using the TZA, the 3x Small Cap Bear ETP paired with TMV. This week, we will explore Hedged Convexity Capture using SPXU, a 3x inverse S&P 500 ETP.

As before, we will use some simple rules:

I. Short SPXU with 50% of the dollar value of the portfolio and Short TMV with 50% of the dollar value of the portfolio.

II. Rebalance the portfolio weekly to the 50%/50% dollar value split.

Here are the results in a graph with a Log scale:

(click to enlarge)

(click to enlarge)

What's notable is that, again, we have a large increase in the Sharpe ratio. And more importantly, the CAGR divided by the strategy's Max Drawdown exceeds 2, whereas for the S&P 500, the CAGR divided by the Max Drawdown over the same period is less than 1.

Objectively, this means that over the same period, that the strategy's reward to risk ratio is twice as favorable as that of the S&P 500. Notably, the strategy has a correlation over the entire period of 0.46 to 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.

Examining the strategy's performance in 2011 is especially instructive for those who believe that capturing negative convexity is always riskier than simply going long the S&P 500.

(click to enlarge)

During the choppy market of 2011, Hedged Convexity Capture had a much higher Sharpe ratio and a much higher return to risk ratio than the S&P 500. This does not mean that this massive outperformance will continue, but it does mean that the strategy is well 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.

Source: Hedged Convexity Capture Part II