by Maz Jadallah
This market has got us a little “hedge trigger” happy. I was having a conversation (more like a debate) late last year with a financial advisor at a very large wealth management firm about our dynamic hedge rule. To refresh your memory, our rule works off of the 200 day simple moving average for the S&P 500. At the end of every month, we look at the index against its 200 SMA. If the index closes below the average, we hedge and wait till the end of the following month to evaluate whether we remove the hedge or maintain it. We remove it if the S&P 500 closes above its 200 SMA at any month end.
That’s the thing – this financial advisor didn’t like our month end rule very much. “Why would you make it so arbitrary as the end of every month? Why not just establish a fixed number of days, like 5, where if the index stays below it’s 200 SMA for those number of days, then hedge?”. Fair enough I said – but it’s not really arbitrary – it’s very systematic. Yes, there is some variability involved in the number of days the index stays continuously below its 200 SMA before the hedge at the end of the month but in the end the only difference between the “5 day” rule and the “month end” rule would be in the timing of the entry or exit month in and out of the hedge. In any case, I said, the “month end” rule works better than the “5 day” rule because it would, on average, hedge less frequently that the “5 Day rule”. Since the market has a upward trending bias – the less you hedge and still offer protection during multi month drawdowns, the better.
Here’s the proof. Below is an analysis of the “5 day” rule vs. the “month end” rule from 1950 to 2014 based on a daily time series. We assume a portfolio would return the S&P 500 when not hedged and 2% cash when hedged. Both strategies have the exact same maximum drawdown on exactly the same date but the “month end” rule outperforms on returns by quite a bit. One thing for sure, having a systematic rule is better than not having one at all.