MaverickBian

China ETF Safety Net: Protect Against Downside Risk

A great piece on the hedging advice.

However, if you dig into much deeper, you may need to answer the following tough questions in the first place:

1. You mentioned although China A-share was up by 50%+ so far, FXI was only up by 3.44%. My question is in the event that China A-share were to shed by 50%+, yet FXI only shed by 3.44%, what would happen to your abovementioned hedging strategy? Hedging is supposed to cut the downside risk/max drawdown magnitude when the overall market goes against your portfolio holdings. Yet, in this extreme situation, it seems to me that you lost almost all your premium while protecting for almost nothing. Most importantly, based on the correlation analysis, this FXI has much less correlation with those market risk factors/benchmarks we wish to hedge out, then why should we use this as a hedge? If so, it would be a huge mismatch for your hedging proposal. Then, what’s the probability that this situation will occur? If very large, then your proposed hedge strategy using FXI may not be practical at all.

2. In terms of generating alpha, you may think adding shorts will add the greatest alpha based on a lot of researches, yet in China's case, almost all funds' alpha in magnitude can not even on a par with its beta at least during the past two years of bullish run. Last year, the overall Chinese market was up by around 140%, yet you couldn't find any fund that can deliver an annualized alpha at 140% in 2006, which means if you change directional bet strategy on China's overall market to pair trading or other alpha strategies, your loss in beta far exceeded your gain in alpha, perhaps making your investment unjustifiable. I know a couple of hedge funds using relative value and absolute return while keeping a zero beta in China last year, they only delivered a return at 15% around while most others who were betting on the directional rise of the overall stock market delivered a very spectacular return at 100% neighborhood. My point is if you cut down your beta exposure to China, then your portfolio's major diver will also be cut down significantly and even disappear.

3. Back to the mismatch in hedging portfolio against huge distresses/corrections... if my portfolio is built on small caps, say 2.0 in beta, yet I use 0.2 shorting instruments like FXI, then your hedging strategy was a waste of money because it didn't solve the problem, or only marginally. If you're holding a 0.2 beta portfolio like FXI but you wish to hedge it use a 3 beta vehicle, then this kind of overhedge will both cost a lot more and cut your upside potential dramatically. Personally, I think if you're pursue a 30% annualized return over the next 5 years, you can keep a small beta below 0.5 while managing a 15% alpha, which is the very optimal solution based on my research. Unfortunately, most funds have little or no alpha at all, and adding short does add some alpha, but it's a double-bladed sword: just don't let it hurt you more while you benefit less.

4. What’s the put option liquidity on FXI is also my concern. If I’m a hedge fund manager and operating half a billion, can I hedge my portfolio using FXI puts? If yes, use put at what strike price, short-dated or long-dated? If you closely look at these issues seriously, I would say you may want to resort to other solutions. To my knowledge, most talented short managers only use S&P 500 or the like because of the liquidity constraint. If you’re only a retail investor managing a small amount of money, that may not become a big issue.

There’re too many topics in the hedging strategy, but all in all, all hedging will lead to a cost, sometimes very expensive and even fruitless. As long as the benefits can justify the hedging costs, you can consider doing it. Although hedging can make you long live, it can also make you below average most of time after deducting the expensive hedging costs. And you can also build a beta-neutral, gamma-neutral portfolio, but based on my research, most neutrality and relative strategy only deliver a so-so or below average return among all strategies, which may explain why Taxes Teachers Pension System would like to propose a 15% emerging market exposure UNHEGED.

Just my 2 cents.

Maverick500