How To Survive A Drop In Stocks And Bonds - Part 4

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Includes: EDZ, TMF, UPRO, XIV
by: Harry Long

Summary

This index got a massive response from readers.

It was built to survive extreme scenarios.

The index can also can outperform the market.

Here is a performance update after all the controversy.

We have now proven that even when emerging markets outperform, that this strategy index has the possibility of an excellent MAR ratio.

The aim of this index is to create a hedge if both stocks and bonds drop, which is a real risk factor. Emerging markets tend to sell off faster and harder than developed markets during a crisis. By pairing short vol, long equity, and long duration government bond exposure with a leveraged short position in emerging markets, we have an interesting tail hedge. Even when emerging markets rise, in a risk off regime, the inverse volatility position skyrockets, allowing us the possibility of profits even in a bull market in emerging markets.

Here are the index's rules:

I. Buy VelocityShares Daily Inverse VIX Short-Term ETN (XIV) with 10% of the dollar value of the portfolio.

II. Buy ProShares UltraPro S&P 500 ETF (UPRO) with 40% of the dollar value of the portfolio.

III. Buy Direxion Daily 30-Year Treasury Bull 3x Shares ETF (TMF) with 35% of the dollar value of the portfolio.

IV. Buy Direxion Daily Emerging Markets Bear 3x Shares ETF (EDZ) with 15% of the dollar value of the portfolio.

V. Rebalance weekly to maintain the 10%/40%/35%/15% dollar value split between the instruments.

Here are the updated results:

The results are superb. We have identified another variation of the strategy which has more historical data. Here are the variation's rules:

I. Buy ProShares UltraPro S&P 500 ETF (NYSEARCA:UPRO) with 50% of the dollar value of the portfolio.

II. Buy Direxion Daily 30-Year Treasury Bull 3x Shares ETF (NYSEARCA:TMF) with 40% of the dollar value of the portfolio.

III. Buy Direxion Daily Emerging Markets Bear 3x Shares ETF (NYSEARCA:EDZ) with 10% of the dollar value of the portfolio.

IV. Rebalance weekly to maintain the 50%/40%/10% dollar value split between the instruments.

Here are the results:

By eliminating XIV from this variation of the index, we are able to peer farther back into the past. It's remarkable that in addition to providing a leveraged tail hedge in the from of EDZ, which gives 3X the inverse return of emerging markets, that the strategy outperforms in all but two of the periods observed (we only have half a year of 2009 where all of the instruments existed). And YTD, the old and modified versions of the index are not only trouncing the SPY, but also doing so with a fraction of the drawdown.

It is important to note that the index performs so well, because when developed markets drop, emerging markets tend to get hammered down even harder. Although long duration government bonds may not always move inversely to the S&P 500, emerging markets almost always drop in sympathy with the S&P, providing a far more direct hedge. That's why, in a year like 2011, the modified index crushes the S&P 500 and does so with a fraction of the drawdown.

These strategy indices outperform the market so drastically, that they should cause investors to question the wisdom of traditional active management. Multi-asset class exposures chosen for their risk/return characteristics and correlation profiles far exceeds the performance of traditional stock picking.

Here is the strategy's major risk: a global geopolitical shift in which emerging markets are viewed as less risky than developed markets.This scenario may not be that far-fetched. If the U.S. enters a multi-decade stagnation, as Japan has experienced since 1991, there is a very real possibility that emerging markets could outperform U.S. stocks. Of course, such a scenario could destroy the performance of this index.

Therefore, a 20% drop in the index, at any time whatsoever, should cause an investor to move to cash for 40 trading days before contemplating any re-entry. The evaluation of the strategy should focus on two central questions: during global market drops, do emerging market stocks still drop far more than developed country stocks? And second, during global bull markets, do developed markets keep pace? If the answer to either question is "no" the strategy should be immediately abandoned.

It's important to understand the performance drivers behind an index. Once we understand what's driving performance, we can understand why a strategy is working and what should cause it to be abandoned. Nothing works forever, especially in financial markets, but a rational framework of analysis definitely helps.

I hope I have provoked some lively discussion on the advantages of funding large leveraged tail hedges, ironically, by taking outsized long exposures.

Thanks for reading.

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Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown; in fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk of actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all which can adversely affect trading results.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in TMF over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.