Markets are in a Halloween mood and investors are spooked. Like Halloween, extreme volatility events have become an annual event in the market cycle. As we discussed in our blog article, the current dislocation was severe enough to trigger our dynamic hedge at the end of August. We frequently remind investors that the hedge is intended to protect our strategies from severe draw downs, which we define as greater than 20%-25%, while at the same time allowing them to be long-only during sustained multi-month market run ups. Our rules-based investment approach seeks to provide discipline, especially during environments of extreme volatility and disruption.
In our performance update last month, we highlighted ALPHACLN Index’s significant overweight in Healthcare stocks, which is winning the most terrifying costume award. The sector’s severe sell off over the past several weeks has thus significantly impacted the strategies. As of the end of last week our ALPHACLN Index has returned -6.0% for October MTD compared with SPY +8.3%. MTD. Excluding the effect of the hedge on performance for the month, the index longs have returned +2.2% MTD. For reference, the iShares US Healthcare ETF (IYH) was +4.1% MTD. In addition, while the hedge added value in September, it has hurt performance this month. The table below summarizes the monthly performance of the index’s long and short positions since scare season started.
The net result is that the ALPHACLN Index has given up a significant year-to-date gain over the SPY at the end of July (+8.9% vs +2.4%) and is now significantly lagging the market (-9.6% vs +1.0%) for the year. Despite the dramatic events this fall, the index’s maximum decline from peak (max drawdown) was just shy of 20%, within the tolerance the strategy has been designed to sustain. It is also worth noting that through Friday, since the hedge was implemented it has had a total “cost” of 6.2%, which is in-line with the historical average when our rule has resulted in a false signal (see link above to read our article on this). Of course we won’t know the final cost (or benefit) until the hedge is finally triggered off.(* Oct performance MTD through Friday, October 23)
So where to from here? Will healthcare rally? Will our hedge trigger off at the end of this month? Here’s the truth – no one knows for sure. But regardless of what happens, we have a framework for systematic decision making. On the long side, we’ll find out on November 27, 2015, when we rebalance our index next. Will the world’s most established stock pickers cut and run on Healthcare, or will they view this as one of those rare buying opportunities? On the short side, we’ll find out sooner. Should the S&P 500 index close above its 200 simple moving average at the end of this week, the hedge will be removed. Otherwise, our strategies will remain hedged throughout November.
The larger point isn’t about the recent market haunts but whether or not our strategies, through their systematic framework, can help long term investors stay the course while out performing the broader market over time. Investors who held our strategies through the extreme volatility in 2011 and continue to hold them today have done exactly that.