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 against unrecoverable or catastrophic losses.
Another thought is that I’m not sure we can expect another sharp spike in volatility similar to 2008. So it wouldn’t be wise to expect to make large gains when the market falls in the future. The period from 2010 till now is probably a better example of a “normal” market. It mostly rose, but contained a couple of surprises to the downside.
The period from 2012 through 2013 was a market with very few downside shocks. As a result, hedging when our market risk indicator signaled caused every hedged portfolio to lag the market. The lesson to be learned from all of these examples is that a hedged portfolio will lag during choppy and up trending markets, but should outperform during severe down trends…and hopefully have larger gains over the long run.