Kurtis Hemmerling's  Instablog

Almost every investor would love to beat the market...but this is no easy task. The reason it is so difficult goes way beyond strategy - it stabs to the heart of each investor...his emotions.

High Gains and Losses

At Portfolio Cafe it is my job to create high alpha trading and investing strategies. One of the most difficult aspects is during periods of heavy drawdown - when those high gains turn to wide losses. Yet this is the nature of these systems even with market timing factors in the S&P 500 (SPY).

I can think of one previously high-performing system, the Sub $15 Small Caps. Using small amounts of capital and market timing, this system has generated an annualized 60% gain (trading costs would lower this substantially though). But who has the guts to keep actively trading this system even when down over 30%...and that's with aggressive market timing rules? The gain sounds good but all too many cannot stomach the losses to achieve the gains.

Hedging for Lower Volatility

In light of the difficulty most investors have following such a system, I chose to add hedging into many of my strategies. The strategy below is NOT one of my strategies, but I have used it for illustrative purposes only. The strategy below is one that looks for low volatility stocks in the S&P 500. It has the following:

Equal weight S&P 500 index, bottom 50% of S&P as to beta, top 50% of S&P as to beta, bottom 10% of S&P as to beta and top 10% of S&P as to beta. There is no hedging, 50% hedging and 100% hedging using an inverse S&P 500 ETF (SH).

The results show that the hedge lowers volatility and drawdown for a smoother ride, although it also lowers annualized returns. You also need to take into consideration the cost of the hedge - either you use lots of capital that could be better spent elsewhere or you use margin and lower your annual growth by another .5 - 1%. I have highlighted in orange one that has lower volatility and drawdown while not losing too much CAGR.

(click to enlarge)

Final Thoughts

A great system does you no good what-so-ever if you don't have the stomach to follow it. The key is to know how much pain you can endure and stay the course. Don't kid yourself that you can take a 70% loss and keep coming back for more.

Once you know how much loss you can accept, look among the various strategies for gain, drawdown and average volatility. From there, run various scenarios to see the effects of hedging using a variety of instruments and amounts. Get it to a level that you can live with. Great ideas need to be coupled with capable execution without hesitation.