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At the end of my 8/3/11 update of the Triple-Play Income Strategy, I stated that I’d be exploring the possibility of using short ETFs to hedge against capital losses in a bear market and that I’d share with the Seeking Alpha community any workable ideas that came to light. Here’s where I am so far.

I tested the idea of adding the Direxion Russell 3000 3X Bear ETF (NYSEARCA:TZA) to the income portfolio presented in my article August 3.

Before discussing results, I need to cover some preliminary points.

First, I think the investment community’s understanding of how to use leverage ETFs has come a long way since these products were introduced. They were greeted with considerable hysteria on the part of supposedly reputable gurus, and even regulators, who believed investors would get flummoxed by the daily re-sets (if a market goes down 25% in a year, you can assume a triple leveraged ETF geared to a one-year horizon will rise 75%, but you cannot make that same assumption if the percent targeting is done on a daily basis). The topic has been covered to death by now and I’m assuming most investors recognize and have learned how to cope with daily targeting. If you want a refresher, you can click the article above on the topic and follow links there (and below this post) to related articles.

Second, I choose an ETF based on the Russell 3000 because I want the extra volatility it offers. Every penny I put into a hedge vehicle reduces the portfolio yield. I said on August 3, that the average yield of the full list was 6.14%. If I allocate ten percent of my assets to TZA or any other hedge vehicle, my realized yield gets cut to 5.53% (because I’d be earning 6.14% on only 90% of the portfolio and getting a zero yield on the other 10%). Hence it’s important that funds allocated to a hedge vehicle provide as big a bang for the buck as possible.

Third, I recognize the income hit and am willing to treat it as akin the cost of an insurance policy; insurance against huge capital losses. That is the essence of hedging. It’s never a zero-cost strategy, and in fact, the word “insurance” does, occasionally creep into the hedging vernacular.

Finally, I’m choosing to go the leveraged ETF route instead of writing call options. Writing calls will allow you to boost income a bit, but this strategy won’t provide much downside protection. I’m sure call writers have seen this in the past week. It is one thing to use premiums received to offset modest or routine share price declines. But when it comes to big ones, the sort we’re really most afraid of, call premiums are just a drop in the bucket. And if you want to pursue a long-term strategy, you’ll often find your best stocks called away from you at below-market prices, forcing you to chase them or comparable issues, at escalating prices.

The strategy I tested involves making a stake in TZA a permanent part of my income strategy. In other words, I’m assuming I’m completely inept at market timing and that I’m going to hold TZA at all times regardless of market conditions. Executing the test was not straightforward, since my test goes back to 3/31/01 while TZA has been in existence only since 11/19/08. But TZA’s price action is no mystery. It is based on the Russell 2000 and we have daily data on that going back to way before 3/31/01. It is true that ETFs like TZA are imprecise; they don’t exactly hit their daily target returns. But I’ve studied the issue several times and find the tracking error to be random (i.e. it helps you just as often as it hurts you) and trivial. I’ve found (from experience with my newsletter) that long-term historical tests conducted by using a pro forma stand-in for TZA (which I get simply by multiplying the daily percent change in the Russell 2000 by minus 3) paint pictures that have proven very representative of my real-money experience with the actual ETF. Note, too, that while a long-term price chart for a daily triple short ETF like TZA will, over a prolonged period, look downright frightening (given that over time, stocks went up a lot more often than they went down), that is not representative of TZA’s role as a hedge vehicle. I don’t simply buy and hold TZA. As I rebalance the portfolio, I’m constantly re-adjusting my position (i.e. averaging down during up markets and averaging up during down markets). So TZA’s price history, viewed in isolation, is irrelevant. What is relevant is the impact it makes on overall portfolio value.

So here, at last, are the results.

Figure 1 compares the back-tested performance of the full Triple Play portfolio as presented on August 3, (the blue line) with its performance assuming a permanent 10% position in my pro forma TZA stand-in (the red line). I re-balance the pro-forma TZA stake to 10% every time I rebalance the portfolio.

Figure 1 - (click charts to enlarge)


From start to finish, the hedge does reduce total return. That shouldn’t be surprising. The market was strong more often than not, so any bear-oriented strategy will ultimately subtract more than it adds. The point of hedging is to reduce volatility, leaving it up to the investor to decide for himself or herself if the risk-return tradeoff is worthwhile. We see in Figure 1 that volatility was reduced quite a bit, but not eliminated. The peak-to-trough drawdown was cut from about 65% to about 45%, still bad, but an improvement.

Most interesting about Figure 1 is that most of the period (i.e. up to 2007-08 and again in 2009-10) was almost a worst-case scenario for hedging, horrible times to have daily triple-short Russell 2000 exposure. Yet overall performance wasn’t a disaster. Portfolio start-to-end share price performance averaged plus 5.1% on an annualized basis and the annualized average yield was 8.0%. That’s not as good as the un-hedged numbers (average annual price gain of 7.3% and average yield of 8.9%), but not a disaster considering how ill-timed most of the hedges were.

Figure 2 changes the hedge by making it 20% of the portfolio rather than 10%.

Figure 2

That is a game changer. The current yield now falls from 6.14% to 4.91%. The test-period annual average yield falls from its original 8.9% level to 7.1%, while the start-to-end average annual share price change falls from 7.3% to 1.9%. The peak-to-trough drawdown was about 25%, compared with approximately 65% for the un-hedged portfolio. And again, most of the period witnessed up markets, which were quite hostile to triple-short hedges.

Going forward, I can’t tell you what to do. As noted, risk-reward tradeoffs always boil down to individual preferences. Speaking for myself, I inserted a 10% stake in TZA into my own Triple-Play Income portfolio this morning; a starter hedge. I haven’t yet determined if I’ll raise the hedge, but I’m thinking about it. An important consideration will be my assessment of the future. I suspect the years ahead will be much friendlier to bearish hedges than were most of the past ten years. I also need to study an alternative to maintaining the hedge on a permanent basis, as well as alternative hedge vehicles (i.e. leveraged short fixed-income exposure). I’ll continue to share new ideas, as they develop, with Seeking Alpha readers.

Disclosure: I added TZA to my existing Triple Play Income positions.

Source: Hedging the Triple Play Income Strategy