A Weird All-Long Strategy (That Beats The S&P 500 Every Year) II

Summary

• I was too hard on this strategy originally.
• I like its strengths.
• Modifying the strategy creates a unique tail-hedge index.

Here are the weird strategy's rules.

1. Buy the Direxion Daily S&P 500 Bull 3X Shares ETF (SPXL) with 50% of the dollar value of the portfolio.

2. Buy the Direxion Daily 30-Year Treasury Bull 3x Shares ETF (TMF) with 45% of the dollar value of the portfolio.

3. Buy the iPath S&P 500 VIX Short-Term Futures ETN (VXX) with 5% of the dollar value of the portfolio.

4. Rebalance annually to maintain the 50%/45%/5% dollar value split between the positions.

Here are the strategy's results in a linear scale:

And in a log scale:

YTD, this weird strategy has destroyed the market, as it has every year since inception:

And in during the recent market volatility, it has done well:

I think a few things are going on. Clearly, we have had a bull market in equities and bonds, which makes things look rosy. However, we also have a long volatility position, so we are not solely hedging in the Long Bond market.

During 2011, and during the recent market volatility, the strategy massively outperformed.

Here is the strategy's performance during 2011, when equities had a major drawdown:

Even better than the strategy's absolute return performance in 2011 was the correlation, which was -0.10 to the SPY.

What could we do to modify the strategy to reduce its reliance on Long Bonds for hedging and further reduce its correlation to equities?

Let's change the rules a bit.

1. Buy SPXL with 50% of the dollar value of the portfolio.

2. Buy TMF with 40% of the dollar value of the portfolio.

3. Buy the VelocityShares Daily 2x VIX Short-Term ETN (TVIX) with 10% of the dollar value of the portfolio.

4. Rebalance annually to maintain the 50%/40%/10% dollar value split between the positions.

Here are the strategy's results in a linear scale:

We have succeeded in dramatically reducing the correlation to the SPY from 0.39 to 0.19. And while the strategy no longer beats the market every year, its CAGR still exceeds the SPY's by over 10 percentage points per year. And with a 10% allocation to TVIX, which gives 2x the performance of VXX, no one could logically argue that the strategy merely relies on the Long Bond market for hedging.

And in reality, the only reason the correlation appears to be 0.19 is that both the strategy and the SPY are largely drifting upwards for most of the period examined. During the recent market volatility starting on September 15th of this year, the original strategy had a correlation to the SPY of 0.55. The new modified strategy has a correlation of -0.21 to the SPY during the same period, proving the point that the strategy is long Gamma during periods of market stress, and in reality, has a 0 or negative correlation across a full bull/bear cycle.

Here is a graph of the modified strategy since September 15th:

In effect, the modified strategy is essentially a tail-hedge index which, paradoxically, exceeds the market's performance, on average, even during a bull market. Not bad at all.

This strategy index would be perfect for an ETF provider which wishes to launch a tail-hedge product which can beat the SPY even in a bull market.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.