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More Thoughts on the Volatility Hedge

I got a few questions about the volatility hedge strategy that I mentioned yesterday that provoked a few thoughts  I thought might interest you.  The first thought is that there is no need to go all the way to 50% hedged with XVZ (and 50% long) when our market risk indicator signals.  I personally use a large hedge when it signals because the indicator is designed to warn of an acceleration to the downside.  As a result, I’m willing to give up some upside gains on whip saws for the chance of making money if the market falls rapidly…and volatility rises.  However, I recognize that you may have different goals than mine so here’s a performance chart that shows varying sizes of the hedge.  Notice that a hedge below 20% (80% long and 20% XVZ) would have resulted in the portfolio continuing to fall with the market during the 2008 financial crisis.  However, during a large swift draw down a 20% hedge with volatility was enough to protect the portfolio

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Volatility as a Hedge Update

Hedging With Volatility

Here’s an update of a post I did back in May where we showed how a volatility ETF (XVZ) can be used as an easy way to hedge when market risk is high.  I use our Market Risk Indicator to signal that there is a high risk that the market is going to accelerate to the downside and an appropriate time to hedge.  This creates a simple hedge strategy for long term investors.  The nice thing about this hedge is that our risk indicator doesn’t signal often so changes to the portfolio are few and far between.  For example, from July of 2004 (as far as my XVZ data goes back) until July of 2007 there were no signals. When perceptions of risk get high our market risk indicator tends to signal more.  From July of 2007 until September of 2008 there were several signals as the housing and banking crisis was coming to the attention of investors.  During 2013 the indicator didn’t signal which made for easy investment and

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2013 Portfolio Performance

2013 was a decent, but not great year for the Downside Hedge portfolios.  The hedged portfolio performed the best (which is normal in an uptrend) gaining nearly 25% on the year. In contrast, the S&P 500 Index (SPX) gained roughly 30% for the year.  The under performance of the hedged portfolio is a result of being hedged (to as much as 50%) early in the year.  From late May the portfolio only had a few instances of hedging while at the same time the longs in the portfolio had their largest gains and outperformed SPX which allowed the portfolio to catch up somewhat.  For official tracking purposes I use a couple of ETFs that have fairly high beta as the longs.  I’m very comfortable with the gains considering the fact that the portfolio is designed to catch most of the upside, but protect against catastrophic losses. Below is a performance chart of the hedged portfolio. The long / cash portfolios substantially under performed the S&P 500 index with the core

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Market Showing Healthy Signs – Adding Long Exposure

Stock Market Internal Health

  Over the past week most of our core market health indicators improved.  Our measures of the economy are still negative, but improving slowly.  Our measures of risk showed some weakness that signals investors are getting a bit more concerned about the market.  However, we believe that this is a normal condition when the market stalls rather than an indication of substantially lower prices. Our measures of market quality, trend, and strength jumped substantially this week.  It is interesting that our measures of trend followed quality and strength in going positive especially since the rally out of the November lows has trended so strongly.  It is an indication of how odd this rally has been from a underlying technical perspective. The positive changes in market trend is causing a change in our core portfolio allocations.  Our Long / Cash strategies are now 80% long and 20% cash.  Our Hedged portfolio is now 90% long and 10% short (using a simple short of the S&P 500 Index — or the ETF

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Long / Cash Portfolio Performance 2012

Long / Cash Portfolio Performance

For the year 2012 our Core Long / Cash portfolio gained 5.42%.  For tracking purposes we simply use the S&P 500 Index (SPX) as the long portion of the portfolio, however, you can use the core portfolio signals to increase or decrease exposure to an actively managed portfolio of stocks. Our Long / Cash portfolio that uses our market risk indicator  gained 7.0% in 2012. It outperformed or Core portfolio due to a couple of instances where it went to cash just before a market decline.  As expected, for a year where the market is in a choppy uptrend the two Long / Cash portfolios under performed SPX.  We feel both portfolios had a good year considering the possible tail risk events in 2012. The chart above compares SPX to our two strategies.  The black line represents SPX, the green line represents our Core Long / Cash strategy, and the red line represents our Long / Cash strategy incorporating our market risk indicator. If you look closely at the chart

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Long / Short Portfolio Performance 2012

Long Short Portfolio Performance

For the year 2012 our Long / Short Hedged portfolio gained 1.26%.  Not a great year when measured against the S&P 500 Index (SPX) which was up 13.4%.  The portfolio is up 104.2% since inception on 7/3/2006.  Most of the under performance during 2012 was a result of being aggressively hedged twice where the market didn’t suffer a substantial decline.  In addition, from mid March thru the middle of May the portfolio gave back some gains it had achieved during the rally from the first part of the year.  We’re comfortable that the portfolio eked out a small gain considering all the potential tail risk events of 2012.     On the chart above we compare the performance of the S&P 500 Index against our Long / Short Hedged portfolio from its inception on 7/3/2006. On the chart below the green lines represent when we added long exposure (and reduced hedges).  The yellow lines represent reducing longs and increasing shorts (using a simple short of SPY)  in the portfolio.  The

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When Machines Take Control

Today it was reported that Knight Capital had a problem with their trading and market making algorithms which caused the NYSE to review the trades of 148 stocks earlier in the day.  Their review concluded that trades in six stocks would be canceled if they fell outside of a 30% band (either high or low from the day’s open).  Bottom line, a machine ran amok. Days like today make us feel glad we hedge.  Just as we did on May 6th, 2010…the flash crash. We didn’t see any problems in the market and in fact our hedging strategy was adding exposure.  We got 60% exposed (80% long and 20% short) on 4/5/2010.  It looked to us according to all our core indicators that this was a rally that might stick.  Then during the week of of April 26th 2010 our market risk indicator flashed.  It closed the week with a Market Risk Warning so on Monday the 3rd our portfolio was fully hedged.  The first few days of the week

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