The Rabbit Hole Of Hedged Convexity Capture

by: Harry Long


Critics claim that HCC is dependent upon a buoyant bond market.

The critics are wrong.

Here's the proof.

You take the blue pill--the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill--you stay in Wonderland, and I show you how deep the rabbit-hole goes.

--Morpheus, The Matrix

In my last article on Structural Arbitrage and Hedged Convexity Capture, I explained that "what separates a shrewd macro investor from an average macro investor is not their views, but the instruments they use to express those views."

As I have stated many times before, our publicly released versions of Hedged Convexity Capture have been simplistic by design. Think of our indices as explicating one of two factors which are rarely harvested in the financial markets. Then consider how much more profitable it has been to harvest even one of these inefficiencies compared to more common factors/phenomenon such as momentum.

Once the indices are viewed in this light, readers can stop expecting them to be an investment panacea. Rather, they should be viewed as potentially fruitful starting points for further investigation in the financial markets.

Even though I have been very clear that readers using these simple public benchmarks should close out their positions and join me on the beach (literally, figuratively, and financially), I have received substantial communications from readers who are heedless of my warnings. Some are still continuing to use the simplistic public versions of these strategies, believing the profits are magical compared to anything else they have used. Even though their gung-ho confidence in our methods is flattering, I am very sincere when I say that our publicly disclosed strategies should be starting points for further investigation on the part of readers--not a combat-ready strategy index that we would provide to clients

On the other extreme, critics of our approach continually insist that Hedged Convexity Capture is solely dependent upon using the government bonds markets as an imperfect hedge--more specifically a bond bull market. However, the critics are wrong, and we can prove it.

Shrewd readers have already suggested that there are a wide variety of ways to capture convexity in a hedged manner, such as using options to hedge tail risk and diversify hedging sources, etc. And they are correct, even though some critics have incorrectly claimed this would destroy the profitability of the strategy.

Like any quantitative question, we can prove that Hedged Convexity Capture is not solely dependent upon a buoyant bond market for hedging with data. Indeed, the market provides a real time laboratory to test ideas.

We can examine the question with the following rules:

I. Short SPXU (NYSEARCA:SPXU) with 40% of the dollar value of the portfolio.

II. Short TMV (NYSEARCA:TMV) with 40% of the dollar value of the portfolio.

III. Go long VXZ (NYSEARCA:VXZ) with 20% of the dollar value of the portfolio.

IV. Rebalance weekly to maintain the 40%/40%/20% dollar value split between the positions.

Here is the logic for these testing rules. The original long-biased version of Hedged Convexity capture used a 50%/50% dollar value split between SPXU and TMV. Using 40%/40% maintains the 1 to 1 ratio for testing purposes. When doing an experiment, we try to keep everything else equal except for the phenomenon we are testing.

Now, the introduction of the 20% long VXZ position represents an additional form of hedging in the Mid-Term Volatility market. It is elegantly simple to use Mid-Term Volatility to test tail hedges.

Here is a graph of the results in a linear scale:

And here is a graph of the results in a log scale:

Higher returns, MAR, and Sharpe than the SPY (NYSEARCA:SPY) ETF. The strategy also has a low correlation to the SPY. Need I say more? The introduction of alternative sources of hedging does not destroy the profitability of Hedged Convexity Capture. We have proven the point.

"I imagine that right now, you're feeling a bit like Alice. Hmm? Tumbling down the rabbit hole?" *

Highlighting the performance during the unpleasantness of 2011 is equally impressive.

Again, even this more advanced strategy is simplistic compared to strategy indices we create for clients, but it proves that there are a variety of ways to hedge risk when using Hedged Convexity Capture.

I hope you've been enjoying the beach.

* Quote from Morpheus, The Matrix

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.