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Medium-term horizon, long/short equity, research analyst, portfolio strategy
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REVIEW

In my previous article, I put forward two portfolios, based on different selection criteria, the first based on finding good stocks with consistent earnings, the second to exploit a possible trading pattern observed in past market corrections. These portfolios were:


(Click to enlarge)

How have they fared?

The 3-month alpha trajectory for each is:


Clearly, the portfolio formed from trading patterns associated with past market corrections has not added alpha in the past week. The outcome is not considered bad in the circumstances, but it is well below expectations. The fact that we do not have a linear increase in alpha means it’s the wrong portfolio.

Attribution

At the time, I identified potentially problematic stocks as RVI, SUN and BT. Attribution analysis shows that both RVI and BT under performed substantially, as did FFG. The remaining stocks could not overcome this drag on performance.

While there were losses in the Ongoing "ANTS" portfolio, they were relatively minor by comparison.

The takeaway is that quality is the best policy.

ADDITIONAL WORK

Not all stocks in the "Correction" portfolio returned poor results in the period. I decided to mix and match the two portfolios to see if a hybrid produced better results than either of them.

After extensive portfolio construction, I could not find a better outcome than that exhibited by "ANTS." The takeaway, from this is that my original methodology is working, and I will stick with it.

Nevertheless, my analysis shows a slightly increasing downside risk that I cannot mitigate with alternative stock selections. So, if this is a correction, I need to consider other ways of generating consistent alpha. I decided to look at inverse ETF’s as hedging tools.

WHAT ABOUT HEDGING?

There is extensive literature on SeekingAlpha about the efficiency of various hedging ETF’s. I investigated several of these to see how they might perform in my case. The strategies are:

  • 130/30 portfolios shorting the SPY.
  • Addition of VXX to 10% ofthe portfolio.
  • Addition of SH (ProShares Short S&P 500 ETF) to 10% of the portfolio.
    • Addition of SDS (ProShares UltraShort S&P 500 ETF) to 10% of the portfolio.

In all cases, I maintained a 100% fully invested portfolio. Therefore, to purchase a hedging instrument meant reducing the portfolio holding to free up cash. It is assumed that the hedge is in place throughout the analysis period.

The results in graphical form are

130/30 Portfolio


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VXX 10%


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SH 10%


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SDS 10%


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DISCUSSION

The results of using SH and SDS speak for themselves, that is, no observable gain in portfolio performance. My view is that in selling a portion of a performing portfolio to buy a hedge product, the hedge product then has to outperform in order to make a positive contribution. In this case they do not. Perhaps the correction is not severe enough.

The VXX product appears to result in periods of increased downside performance and possibly a more volatile portfolio.

My view is that I would consider these products if I was running a high beta portfolio that needed short term protection during periods of negative returns.

The standout is the 130/30 portfolio, which benefits from the declining SPY, and increased exposure to performing stocks.

CONCLUSION

My basic aim is to generate consistent alpha through stock picking and portfolio construction. In a correction phase, I expect difficulties. While always vigilant for long term changes in trend in specific stocks, the appropriate portfolio control appears to be shorting the index.

Disclaimer: The content in this document is provided as general information only and should not be taken as investment advice. The contents in this explanatory paper shall not be construed as a recommendation to buy or sell any security or financial product, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author. The author may or may not have a position in any security referenced herein. Any action that you take as a result of information or analysis on this site is ultimately your responsibility.

Source: Stock Picking or Hedging in a Correction