Seeking Alpha

Conventional Hedging May Not Work In A Rising Rate Environment

Includes: SHY, SPY, TBF, TLT, TMF, TMV
by: Cliff Smith

A new hedging strategy has been developed that should work in both decreasing and increasing rate environments.

The new strategy employs a tactical methodology that chooses the best treasury ETF in any given semi-monthly period.

ETFreplay results are shown for three cases backtested from 2010-present: 1) SPY alone, 2) SPY with conventional hedging, and 3) SPY with the new hedging strategy.

The results show that in 2013, a year marked with rising rates and poor treasury performance, the new strategy shows significant improvement over conventional hedging.

Hedging is a common tactic used in tactical asset allocation strategies to reduce volatility and drawdown while maintaining growth. Frank Grossmann writes about hedging in his blog on his excellent website, and shows the benefits of hedging used in combination with an equity ETF such as the SPDR S&P 500 Index ETF (NYSEARCA:SPY). Grossmann suggests the use of the iShares Barclays Long-Term Treasury Bond (NASDAQ:TLT), +3X Direxion Leveraged 20-Year Treasury Bond (NYSEARCA:TMF) or shorting -3x Direxion Leveraged Short 20-Year Treasury Bond (NYSEARCA:TMV) in 20% of the account, with the other 80% of the account being in an equity strategy. Grossmann backtests to 2009 and presents the good results of hedging.

What concerned me was the use of hedging in 2013 when the performance of long-term treasuries was dismal because of increasing rates. The hedged part of the portfolio did not do well in 2013, although the overall account grew because of the growth of the equity part of the account. Since we can expect treasury rates to increase in the coming month/years, it would seem that hedging might not be as beneficial as it has been in a long-term bull market for treasuries. We are now in a different bond environment.

I decided to try and develop a hedging strategy that was more flexible than just a single ETF like iShares Barclays Long-Term Treasury Bond, +3X Direxion Leveraged 20-Year Treasury Bond or shorting -3x Direxion Leveraged Short 20-Year Treasury Bond. I am not able to short TMV at Schwab (wish I could), so I turned my attention to using TMF as the primary hedging ETF. But rather than just buy and hold TMF, I decided it would be better to use tactical growth methods to select the best treasury in any given period. I ended up using four treasury ETFs in the hedged account universe:

1. TMF;

2. TLT;

3. -1x ProShares Short 20+ Year Treasury Bond (NYSEARCA:TBF); and

4. Barclays Low Duration Treasury Bond (NASDAQ:SHY).

The idea is that TBF should do well in an increasing rate environment, TMF should do well in a decreasing rate environment, and SHY is basically the cash position. Including TLT in the ETF basket seemed to improve the results.

Using the ETFreplay software, I backtested this new hedging strategy from 2010-present. As always, I desired longer backtesting, but TMF and TBF were only initiated in 2009. I found the best tactical strategy used two growth indicators (5-month and 20-day total returns). The strategy was updated on a semi-monthly basis.

The results of the new hedging strategy are presented and compared with TMF as the baseline. It can be seen that the Compounded Annual Growth Rate, CAGR, of the strategy is over 30, and all of the macro increases of TMF are well captured. In 2013, when TMF dropped dramatically due to rising rates, the strategy switched over to TBF as desired, and we see an annual growth of 10.7% while TMF actually lost 39.0%. In 2014, the strategy switched back to TMF. Also note the large growth in 2011 when the equity market dropped significantly and there was movement into long-term treasuries. The strategy produced positive growth every year. There was significant volatility, as expected.

To show how this improves the hedging compared to a constant buy-and-hold strategy of TMF, I present three results from ETFreplay. The first figure shows the results of SPY if one would have bought and held it from 2010 to the present. The CAGR is 15.1%, the volatility is 16.2%, and the maximum drawdown (in 2011) is 18.6%. The Sharpe Ratio is 0.88.

The next figure shows the reduced volatility and drawdown that is produced in a common buy-and-hold hedging technique with TMF as proposed by Grossmann. In this case, 20% of the account is invested in TMF and 80% in SPY. Please note this hedging significantly improves the overall growth as well as reduces the volatility and drawdown. The CAGR has increased to 18.4%, the volatility has decreased to 10.4%, and the maximum drawdown is only 8.9%. The Sharpe Ratio has increased to 1.58.

But we need to focus on 2013 when the hedging with TMF does not produce the desired results. The yearly growth is only 14.7% compared to SPY's growth of 32.3%. This is because the hedged growth in 2013 is a negative 39.0% as shown previously. The hedging has significantly hurt the strategy's performance in 2013, the year that long-term treasury rates increased significantly.

The final figure employs the new hedging strategy I have developed and presented in this article, combined with SPY. The split is again 20% for the hedged part, and 80% for SPY. We again see the benefits of hedging (lower volatility and drawdown) and greater growth compared to just holding SPY. The CAGR is 19.5%, the volatility is 11.1%, and the maximum drawdown is 9.9%. The Sharpe Ratio is 1.55. But if we focus on 2013, we see that the improved hedging strategy has produced much larger returns (27.9% versus only 14.7% for the buy-and-hold hedging strategy in the figure above). This is because the hedging component has produced a growth of 10.7% rather than losing 39.0%.

I would argue that this new hedging strategy I have developed has the potential to do well even in a rate-increasing environment, while the constant buy-and-hold hedging strategy will suffer.

Disclosure: The author is long TMF. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.