Seeking Alpha

The ZOMMA Hedged Convexity Capture Index (Updated)

Includes: SPXU, TMV
by: Harry Long

The index has outperformed.

But I still don't recommend using it.

As an academic study, it's important.

Critics claimed that HCC is dependent upon a buoyant bond market.

The critics were wrong.

You take the blue pill - the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill - you stay in Wonderland, and I show you how deep the rabbit-hole goes. - Morpheus, The Matrix

The idea behind Hedged Convexity Capture (HCC) is to benefit from the path-dependent negative convexity that has been widely observed in leveraged ETP products.

HCC creates crucial advantages to merely being in a leveraged long equity position. Due to the leveraged nature of these ETPs which resets daily, we are not merely capturing the performance of a long S&P 500 index position paired with a 20+ year government bond position. By shorting these leveraged ETPs, we are benefiting from the highly probable path dependent negative convexity associated with these instruments.

This means that we capture return, not only from rising equity markets but also from the strategy when the equity and bond markets move sideways, due to the path-dependent negative convexity of the component ETP instruments created by their daily leverage resets. So, rising bond and equity markets help the strategy, as do sideways-moving bond and equity markets.

And, this is profound, because unlike conventional factor-based equity quant market neutral strategies which are dollar-neutral while being exposed to factors such as quality, growth, and valuation, we are gaining exposure to a factor - path-dependent negative convexity - which is not as widely harvested in the investment world and is therefore much more profitable to target and to capture.

Even though I thought that the index is too dangerous, it has kept performing. Therefore, it's best to view the index as an academic example of the power of the phenomenon of convexity, which we can then harvest as a component of more advanced strategies.

In my last article on Structural Arbitrage and Hedged Convexity Capture, I explained that "what separates a shrewd macro investor from an average macro investor is not their views, but the instruments they use to express those views."

As I have stated many times before, our publicly released versions of Hedged Convexity Capture have been simplistic by design. Think of our indices as explicating one of two factors which are rarely harvested in the financial markets. Then consider how much more profitable it has been to harvest even one of these inefficiencies compared to more common factors/phenomenon such as momentum.

Once the indices are viewed in this light, readers can stop expecting them to be an investment panacea. Rather, they should be viewed as potentially fruitful starting points for further investigation in the financial markets.

Even though I have been very clear that readers using these simple public benchmarks should close out their positions and join me on the beach (literally, figuratively, and financially), I have received substantial communications from readers who are heedless of my warnings.

Some are still continuing to use the simplistic public versions of these strategies, believing the profits are magical compared to anything else they have used. Even though their gung-ho confidence in our methods is flattering, I am very sincere when I say that our publicly disclosed strategies should be starting points for further investigation on the part of readers - not a combat-ready strategy index that we would provide to clients

On the other extreme, critics of our approach continually insist that HCC is solely dependent upon using the government bonds markets as an imperfect hedge - more specifically, a bond bull market. However, the critics are wrong, and we can prove it.

Shrewd readers have already suggested that there are a wide variety of ways to capture convexity in a hedged manner, such as using options to hedge tail risk and diversify hedging sources, etc. And, they are correct, even though some critics have incorrectly claimed this would destroy the profitability of the strategy.

Like any quantitative question, we can prove that Hedged Convexity Capture is not solely dependent upon a buoyant bond market for hedging with data. Indeed, the market provides a real-time laboratory to test ideas.

To review, here are the index's rules:

I. Short SPXU (SPXU) with 50% of the dollar value of the portfolio.

II. Short TMV (TMV) with 50% of the dollar value of the portfolio.

III. Rebalance weekly to maintain the 50%/50% dollar value weighting between the two instruments.

Here are the results:

Not bad for two instruments. Indeed, the convexity itself behaves like a separate asset class.

Because this strategy index uses potentially explosive instruments with almost unlimited tail-risk, this strategy index is far from my favorite. But the index has performed.

The results are important, because they illustrate some strong tendencies.

However, even though this strategy index has tempting performance, the open-ended tail risk is simply unacceptable.

For enterprising hedge funds, which believe they can potentially hedge the tail risk, I would encourage them to consider the use of call options on the VIX index as a method of indirectly hedging tail risk for the SPXU leg of the index. For all others, I would run in the opposite direction while admiring the power of shorting leveraged inverse ETPs from afar.

However, why are phenomenon such as convexity important? Our macro view is that unique intellectual property, based upon science rather than artistry, will drive investment performance in the future. In addition, high quality rules-based strategy indices, marketed through strategy-based ETFs and mutual funds will eclipse hedge funds due to their transparency, liquidity, and low costs.

What will occur is a disintermediation between the creators of high quality systematic investment strategies and traditionally vertically integrated distribution channels. Self-directed investors will be able to find a variety of transparent, systematic, rules-based, high-performance ETF and mutual fund alternatives to traditional high-fee hedge funds. Once the performance and capacity of strategy-based ETFs and mutual funds reaches a tipping point, hedge fund fees and AUM will dramatically drop. In addition, in a vicious cycle, this new competition, seeding increasingly sophisticated investment models with ever-larger AUMs, will lower hedge fund returns, further pressuring fees in the liquid alternatives space.

And, there will be a mad rush by ETF and mutual fund firms with the distribution, size, and scale to introduce strategies which can produce Sharpe ratios of 1.0 and above, and MAR ratios of 2 and above. Serious research, insight, and discipline will again rule the day. That's our macro view of the investment management industry.

For all of the arrogance of the alternative asset management industry and its pretensions of modernity, it really is like the computer industry of 1980, manufacturing expensive, unwieldy, opaque, primitive mainframe computers which are prone to breakdowns. The unstated, yet desperate need of investors everywhere is something which is powerful, simple, elegant, radically transparent, and cheap, like the first Apple computers, or the early PCs. I believe that we are on the cusp of such a revolution, which will free investors from monthly liquidity restrictions, gates, opaque structures, high fees, and undisclosed risks. Evidence-Based Management (EBM) will become the new normal. And, that's a healthy development for modern markets.

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, and no plans to initiate any positions within 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.