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Hair Triggers and Dynamic Hedging - Part 2

We received several great responses to our article on rules for dynamic hedge triggers.  Many of you suggested alternative rules for us to consider.  Two interesting suggestions from our members included 1) using a “double trigger” (50 and 200 period moving average) instead of just a single 200 period moving average and 2) using a "% price excursion" trigger above/below the index moving average.

Double Trigger

Here the rule still only looks at the tirgger at each month end but the strategy would now enter a 33% hedge (75% long/ 25% short) when the index closes below its 50 day simple moving average and a market neutral hedge (50% long / 50% short) when the index closes below its 200 day moving average. Similarly, the strategy would progressively ease up on the hedge level as the index crosses the 200, then 50 day moving averages at any month end.

% Price Excursion

This method looks at the trigger daily and would enter a market neutral hedge when the index closes below the % price threshold set for the strategy.  We experimented with several % price thresholds and it looks like a 2.5% threshold is optimum when this rule is applied on a standalone basis (i.e. its not combined with other rules).  So the hedge is triggered if the index closes 2.5% below its 200 moving average or lower on any day, otherwise the strategy is long only. 

The graph below illustrates the performance of each approach relative to the simple month end, 200 period, single trigger we use currently. Thanks to all who took the time to send in their suggestions. Please keep them coming.

 

 

Reminder!

 This is a great time to sign up for full membership and take advantage of our offer to take 50% off annual membership through 2012. Offer expires November 31, 2011.

 

Hedge Funds’ Returns Continue to be Dominated by Beta

Great paper by Ray Dalio's Bridgewater Associates on the degree to which hedge fund returns are dominated by beta and how high beta correlations are good indicators of future returns.  A must read (paper removed by request from Bridgewater Associates).

Hair Triggers and Dynamic Hedging

This market environment is enough to put any dynamically hedged strategy through its paces.  Ours have performed well in this environment but because of all the excitement the past couple of months, we've been getting a lot of questions about whether our dynamic hedge trigger rule is set to the right sensitivity level. 

If you recall, our current dynamic hedge rule looks for the trigger at each month end only.  So if the market closes below its 200 day moving average mid-month, the trigger is not pulled until it also closes below the threshold at the end of the month.  In other words, we're using monthly sensitivity on the trigger.

But why use monthy?  Why not use "daily" sensitivity instead?  Set to "daily", we'd pull the trigger on any day the market index closes below its 200 day moving average, regardless of where during the month that happened.  We'd pull the trigger again and remove the hedge on any day the index closes above its average and so on.  

With monthly sensitivity, you avoid being whipsawed between being hedged and long only but with daily sensitivity, you remove the "arbitrary-ness" of the month end rule and you allow the strategy to react more quickly.   If you really want to get customized, why not set the hedge trigger to daily when moving from long-to-hedged allocations and then reevaluate at month end to see if the index is still below its average.  This "hybrid" approach combines daily and monthly sensitivities allowing you to be quick on the draw when hedging but aviod some of the whipsawing when the index wants to oscillate above/below its average. Which is better? 

The graph above shows total returns using each of the three sensitivity settings on a portfolio that is 100% long the S&P500 when the trigger is off and 50% long / 50% short the S&P 500 when the trigger is on.  As you can see its not even a contest, monthly sensitivity is by far the superior approach.  But why?  Our guess is that since markets have a long bias, over time you want the strategy that mimimizes the number of days hedged while still being hedged often enough to avoid protracted market contractions (see table).  We'd love to hear other people's point of view.

Total Returns By Trigger Sensitivity

Sensitivity>>	Hybrid	Monthly	Daily
Avg/mo	0.01%	0.02%	0.00%
1year	2.85%	1.62%	-1.37%
3year	14.28%	26.57%	16.09%
5year	13.73%	45.84%	12.50%
Since 2000	15.40%	82.89%	8.09%
Days hedged	1464	1191	1246

 

5 Myths About Cloning Hedge Funds

In a recent webinar, AlphaClone Founder/CEO Maz Jadallah discussed the five most common misconceptions about using hedge fund public disclosures to make investment decisions.  The presentation was moderated by popular investment blogger and Tradestreaming.com author, Zack Miller:

5 Myths About Cloning Hedge Funds

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