This series of articles focuses on the choice of going to cash, hedging, or doing nothing when a bearish signal is triggered. Sectors are some of the factors that should influence the decision. For a consumer staples portfolio, timed hedging appears to be the best solution for the return, but just holding without protection may incur a lower risk (article here). For an industrial portfolio, timed hedging seems once again a better choice for the return, and going to cash brings a lower risk (read here). This third article will look for an answer to the same question in another sector: Healthcare.
For each sector and market capitalization segment, I defined a fundamental ranking process based on my own research. The aim is not an optimal strategy, but something based on common sense and fundamental data to model a portfolio of "good companies" for every sector in S&P 500 and Russell 2000 universes. The S&P 500 Healthcare ranking is simple and uses only two fundamental ratios (that cannot be unveiled here). For the next part, I will use a strategy consisting of a 4-week rotation of the ten stocks of highest rank. It represents about 20% of the reference set: there are currently 55 healthcare companies in the S&P 500 index.
I have performed three 15-year simulations (1/1/1999-12/6/2013): without protection ("NP"), with market timing ("MT") and timed hedged ("TH"). The portfolio is rebalanced every four weeks. The timing indicator is the same for market timing and timed hedging. It is defined by a bearish signal when the S&P 500 current year EPS estimate falls below its own value three months ago, and a bullish signal when it rises above this value. This is an aggregate fundamental indicator. There is no technical analysis here. The hedge is an S&P 500 short position in a 1:1 ratio with the portfolio value (here: shorting SPY).
The next table shows simulation results. Dividends are included, transaction costs are 0.1%. A 2% annualized carry cost is applied for temporary hedging positions.
Like consumer staples, healthcare is a defensive sector: the unprotected portfolio gives a decent return with acceptable drawdown and volatility.
The MT version (going to cash) lowers the risk, at the price of a much lower return.
Once again, the best choice for the return and risk-adjusted performance (Sortino ratio) is timed hedging.
Here is the equity curve of the strategy with timed hedging (in red) compared with SPY (in blue):
This is a dynamic portfolio. On average, 1.6 stock changes every four weeks. Here is an extract of the current portfolio:
Health Care Providers & Services
Health Care Equipment & Supplies
Merck & Co Inc.
*Trailing 12 months, extraordinary items included.
Timed hedging is modeled here in a margin account, and margin costs are included. However, you can execute it without a margin account. Just sell 25% of your portfolio and buy SPXU instead when a bearish signal occurs. Doing so, you have the same protection as shorting SPY in a 1:1 ratio. You may lose a little bit of alpha without leveraging in the downturns on the one hand, but SPXU is a cheaper hedge on the other hand (article here).
The conclusion is that it is not absolutely necessary to time or hedge a good healthcare portfolio. However, timed hedging may bring a significantly better performance and a lower correlation with the benchmark. Going to cash is not a good solution.