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Summary

  • Every version of Hedged Convexity Capture is destroying large and small cap indices.
  • The strategies represent an excellent source of alpha.
  • Evidence-based quant strategies are the future of intelligent investing.
  • Traditional stock-picking cannot effectively compete with advanced quant approaches.

Hedged Convexity Capture is a strategy my firm invented which seeks to capture the negative convexity associated with leveraged ETPs. The idea behind Hedged Convexity Capture, as I outline in my book, is to capture the potential returns from shorting leveraged inverse equity ETPs with lower drawdowns and far higher Sharpe ratios than by just shorting them outright. The strategy seeks to accomplish this by shorting leveraged inverse equity ETPs such as SPXU (NYSEARCA:SPXU) or TZA (NYSEARCA:TZA), and pairing that short with a short position in TMV (NYSEARCA: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 bond hedge.

Hedged Convexity Capture is a perfect example of an actuarial approach to trading. We are making the same shrewd bet on convexity again and again, by focusing on a repeatable phenomenon (remember that concept from science?) called negative convexity. We are not making helter-skelter individual predictions every day like most investors or traders. And when the phenomenon observed is especially strong, the results of that phenomenon become proportionally more predictable. And the negative convexity associated with leveraged inverse ETPs is an especially strong phenomenon.

While would-be hedgers are attempting to lay off market risk by buying inverse leveraged ETPs, they are actually taking on negative convexity risk. And that decision is grossly inefficient, because the negative convexity risk turns out to be, on average (remember, on average!), a far larger risk than the market risk they were seeking to avoid. Therefore, we would be shrewd to take the other side of these trades by using Hedged Convexity Capture.

Today, we will examine four different versions of Hedged Convexity Capture and their ongoing massive outperformance of both large and small cap indices YTD such as the S&P 500 (NYSEARCA:SPY). While these strategies were extremely difficult to create, they are easy to employ using simple rules.

First we will examine Non-Correlated Hedged Convexity Capture. We shall efficiently capture negative convexity in a hedged manner with the following rules:

I. Short SPXU with 40% of the dollar value of the portfolio.

II. Short 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.

Here is a graph of the YTD results, which have achieved a new high even in the face of a choppy broader market:

(click to enlarge)

Extremely impressive. Need I say more?

Next, we will examine plain-vanilla Hedged Convexity Capture which some choose to use because of its long-bias and very moderate correlation to broader market, combined with its simplicity.

As before, we will use some simple rules to efficiently capture convexity:

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

II. Short TMV with 50% of the dollar value of the portfolio.

III. Rebalance weekly to maintain the 50%/50% dollar value weighting between the two instruments.

(click to enlarge)

Making money with an intelligent quantitative approach might feel boring to some, but if the purpose is profit, rather than gambling, I do not need excitement.

Next, we will examine plain-vanilla Non-Correlated Hedged Convexity Capture using TZA, which has extremely strong negative convexity driven by its small-cap roots. We will use some simple rules:

I. Short TZA with 35% of the dollar value of the portfolio.

II. Short TMV with 65% of the dollar value of the portfolio.

III. Rebalance weekly to maintain the 35%/65% dollar value weighting between the two instruments.

(click to enlarge)

As we can see, this strategy destroys VXF, which is an interesting Vanguard ETF which holds stocks outside the S&P 500.

Next, we will examine plain-vanilla Hedged Convexity Capture using TZA which some choose to use because of its long-bias, combined with its simplicity.

As before, we will use some simple rules to efficiently capture convexity:

I. Short TZA with 50% of the dollar value of the portfolio.

II. Short TMV with 50% of the dollar value of the portfolio.

III. Rebalance weekly to maintain the 50%/50% dollar value weighting between the two instruments.

(click to enlarge)

Even the plain-vanilla version destroys the VXF during a difficult time period for smaller companies. Not bad at all. The evidence clearly shows that Hedged Convexity Capture plows throw choppy markets.

However, even though the strategy tests well, I never rely on theory alone. Our more advanced strategies, which are available privately to clients, or occasionally in book form, do not use shorting. I believe Hedged Convexity Capture's major risk, since it uses shorting, is a discontinuous drop in markets, which could cause the SPXU leg of the trade to skyrocket far more than the TMV could drop. In addition, events such as hyper-inflation could cause both government bonds and equities to drop simultaneously.

As I often say, no strategy is even close to perfect. There are only strategies which are preferable to all other possible alternatives. We have created far more advanced strategies for clients which do not use shorting. The public version presented here should stimulate thinking on the part of investors by clearly illustrating that even seemingly simple strategies using powerful mathematical principles can dramatically outperform strategies presented in popular bestsellers, while using fewer instruments with less hassle to implement.

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.

Investors need to make a total change in their approach to markets which embraces data and systematic quantitative techniques. But most investors and traders resist change until they are sick and tired of being sick and tired. Unfortunately, such emotional rock-bottom usually correlates with financial rock-bottom. But as Benjamin Franklin reminds us, only a fool needs to learn from experience.

Evidence-based techniques sell themselves, because they rely on data and repeatable phenomenon discovered by expensive R&D--not witchcraft. The next time your Economist, Shaman, Psychic, Medicine Man, Forecaster, Mystic--I mean broker!--recommends something, ask them for the evidence, just as you would a Doctor.

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.

Source: Part VIII: Hedged Convexity Is Still The World's Best-Performing ETP Strategy