by Maz Jadallah
Don’t Be DiCaprio and Suffer The Market’s Bear Mauling. This article was first published on Valuewalk.
Investors and their financial advisors are wrought with anxiety as the markets continue to correct. As the manager of several strategies that employ a built-in defense mechanism against deep market sell offs, our nerves are perhaps slightly steadier than most. Our rules-based investment approach uses hedge fund 13F disclosures and was developed with market volatility and behavioral biases in mind – when markets exhibit a multi-month downturn, exposures are hedged; when markets rally over multiple months, our strategies maintain their long-only exposure.
As our hedge rule is designed, when the S&P 500 closes below its 200-day average, our strategies short an ETF that tracks the S&P 500 index (SPY) to avoid long-term exposure to what could have been a deep market drawdown. This fear is well founded and supported by historical data. Since 1952, the S&P 500 has suffered drawdowns of 20% or more 11 times (peak to peak), and drawdowns of 30% or more 5 times. In every case except one, those drawdowns occurred after the S&P 500 had closed below its 200-day average at a month-end. It’s not even close, for long term investors, that pay heed to this particular market signal. It’s also worth noting that simple diversification across asset classes (often marketed as the panacea for risk) would have been of very little benefit to investors during those times when the market corrected 30% or more (the maximum drawdown was 61%).
Not withstanding our rule’s historical track record in capturing deep drawdowns, no hedge mechanism is perfect. Two-thirds of the time, despite closing below its 200-day average, the market doesn’t suffer a deep drawdown, but rather rebounds. Late last year is the most recent example, the S&P 500 closed below it’s 200-day average at the end of August and accordingly, our strategies were hedged in September and October. This caused our strategies to miss the 8% rebound in the S&P 500 during October. The net was that the hedge detracted about 6 percentage points of return over the two-month period for those strategies that employ it.
We’ve managed through similar events in the past, and this zig-zag has great historical precedent. While it would have been nice to capitalize on the S&P’s unexpected gains, our strategy is long-term – the cost of missing out on one market upswing pales in comparison to the benefit of protecting assets over huge drawdowns. Historically, the average opportunity cost during “false signal” hedges has been 5% while the average gain on the hedge when it was not a false signal was 20%. In geek speak – that’s called an asymmetric bet that favors the investor.
Regardless of the recent drawdown, taking a longer view on total performance gives investors a more complete picture. Our firm has been running dynamically hedged strategies in separate accounts for nearly six years now. The results speak for themselves – five out of five investment strategies have outperformed their respective passive benchmarks over the past three- and four-year periods. The largest contributor to strategy outperformance has been security selection, and three of the five strategies employ the dynamic hedge. In addition, a three-year window analysis (daily series) of the AlphaClone Hedge Fund Downside Hedged index shows it outperforming the S&P 500 90 percent of the time, from inception through the end of September 2015.
As in life, investing offers no free lunches. If there was a sure-fire way to avoid risk and make money despite the unpredictable nature of the stock market, then we would all be much wealthier and probably more carefree. That is simply not the case – the stock market, by design, will always be unpredictable. The best way to stay the course and reap long-term rewards is to have an ongoing, rules-based discipline that helps you avoid permanent loss of capital.
As fate would have it, our strategies are again hedged this month (January 2016) during a period when global market sentiment is particularly bearish. Is this a whipsaw or the real deal? Regardless, our investors should draw comfort from our dynamic hedge rule.
 In October 1987 the S&P 500 suffered a 21% loss in that month alone and began the month above its 200-day average.