by Brad Bredemann

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When I joined the AlphaClone team a month ago, it never occurred to me that my first blog post would be about our unique Dynamic Hedge.  But markets are notoriously unpredictable and that’s exactly why we use one.

Perhaps the most important learning over my years of professional experience and financial education is respect for the unpredictability of market returns.  A close second would be the realization that we all have behavioral biases which are not helpful to our investment outcomes.  At AlphaClone, we believe that systematic implementation of intelligent portfolio management can improve those outcomes.

The Dynamic Hedge at AlphaClone serves one important function – to protect against large, downside market exposure that has historically existed in down-trending markets (which for our purposes is defined as trading below a 200-day simple moving average).  In statistics parlance, the “fat left tail” in down-trending markets has been significantly destructive to equity portfolios.  By providing market protection during these potentially destructive periods and fully invested for the majority of time, the result is superior compounded investment returns.

We’re not alone in believing markets below this important level are challenging.  Paul Tudor Jones, in his recent interviews for Tony Robbins’ new book, provides an emphatic endorsement.  Our work testing the historical outcomes of the rule going back to 1952 show six periods when the AlphaClone Dynamic Hedge has protected portfolios from 10% or greater market sell-offs.  Three of these six periods were at least 25%, and the largest was a 61% sell-off avoided in 2008/2009.

Hedge Trade Profit Loss %

It should also be noted that many instances of hedging occur for smaller pullbacks, and there is an opportunity cost to being un-invested.  In the same data series, the Dynamic Hedge is implemented a total of 44 times with a “win-rate” of 23% (ie. 10 of the 44 observations protected from a negative outcome over the past 63 years), with a median and average protection of 13% and 19%, respectively.  In the remaining observations, the median and average opportunity costs were 4% and 5%, respectively.

Which brings me back to human behavior.  The likelihood of an investor remaining long following an average pullback of 19% is not high.  And in our view, the opportunity cost of being out of the market as market order returns from these pullbacks is greater than the 5% average cost encountered when the hedge is triggered unnecessarily.

As of last night, the AlphaClone Dynamic Hedge was triggered for all of our “long/short” strategies, systematically moving to protect equity exposure in the current market environment.  We can’t predict how long the hedge will remain in place, or whether it will be highly protective or modestly costly.  But thinking about the market volatility of the past week validates its ability to keep portfolios invested for the long-term.

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