Hedged R2G models

We will allow hedged R2G very soon.

There will be no additional restrictions for models that hedge without margin. These are the models that are long, and use a hedge by first raising cash exiting positions to achieve the desired hedge %.

For hedging with margin (long positions + long hedge on margin, or long positions + short hedge) we will need additional restrictions for the simulation. I think these settings should never get an investor in trouble:

  • Hedge slippage 0.2%
  • Leverage 1.0, Margin cost 1.5%, Maintenance Margin 35%
  • Stop sim if margin is called
  • Disallow some of the more aggressive leveraged ETF’s

We will also need some presentation changes in the R2G pages to clearly show hedge status.

ETA for this is end of next week as we are still ironing our a few quirks. Thanks

Sounds good. Agree with limiting or forcing disclosures on 3X ETF’s.

And your proposed margin rates are way too low.

See:

People are paying between 1.0% and 8% today at most places. Not everyone is at IB.

And we are in a VERY LOW INTEREST rate environment.

And that’s just the US. Many investors will be international.

Need to disclose margin rates and give education around this. Maybe have model providers show returns at three margin rates - 1%, 5% an 10%.

Not to keep making same point, but really best to peg this to fed funds rate or some multiple of bond yields.

This could easily be over 10% for some clients in coming years.

On smaller ETF’s, hedge slippage of 0.2% might not be enough. Variable slippage still preferred (based on liquidity of underlying).

Tom,

We only have one field ‘Margin Carry cost’ used for regular margin (negative cash) and short positions (borrow costs). Shorting an ETF puts cash into your account and the borrow costs for a popular ETF are very low, probably less than 1%. So the requirements should be different for:

Long positions + long ETF on margin: margin 3% ?
Long positions + short ETF: carry cost 1%

I agree that margin should be pegged to something. It’s a future enhancement. Bur for the common hedging of long positions + short hedge should not be a problem

We can’t use variable slippage on smaller ETFs since some volume data is missing, but in the Hedge only popular ETFs are available where liquidity should not be a problem. Also options could be used from more sophisticated investors.

Marco,
Leverage 1.0, Margin cost 1.5%, Maintenance Margin 35%

For leverage of 1.0, there cannot be a margin requirement. I think you meant 2.0 as per your previous communication on this. Also presently the hedge cannot use leverage.

I agree with Tomyani that Margin cost of 1.5% is way too low. This should be an average from 1999 to 2013, whatever this is, but no less than 5% perhaps.

Also it is time to require liquidity filters in R2G models, depending on average holding time. I suggest that the filter percentage should be avg. holding time divided by 3.33. Thus a rapid turnover model with a avg. holding time of 10 days could only buy those stocks where the following applies:
AvgDailyTot(10,0)*0.03 > BuyAmount & AvgDailyTot(10,10)*0.03 > BuyAmount & AvgDailyTot(10,20)*0.03 > BuyAmount & AvgDailyTot(10,30)*0.03 > BuyAmount & AvgDailyTot(10,40)*0.03 > BuyAmount & AvgDailyTot(10,50)*0.03 > BuyAmount.

When the avg. holding time is 50 days, the formula above would use 0.15 instead of 0.03, because trading can be done over a few days.

This would also prevent models from achieving ridiculously high returns, because the portfolio value cannot increase indefinitely due to the fact that the sim will run out of stocks to buy.

Additionally, if there is a liquidity filter requirement, then the initial capital must be equal for all models. Otherwise one could start with $1,000 and still get very high returns, because the sim will find plenty of stocks to buy all the time, wheras if you started with $10MM the sim would soon not find any stocks, and therefore have a lower return than the one which started with $1,000.

Thanks Marco - Would it be possible to start non-margined hedged models before the presentation details are sorted out? No one can trade them for two weeks anyways. I would like to get the track record post-launch started.

Steve

Geov,

Leverage 1.0 is for the main positions only. When a 100% short hedge is preset the leverage goes to 2.0, and carry costs are paid. Shorting in 1999 probably earned you money, so 1% is over-estimating for liquid ETF.

R2G do not need liquidity based on amount being bought, nor an equal starting amount. Just because an R2G is now $10M means nothing to an investor with $50K today. That’s why we do not show # of shares anywhere, just weights of positions. The bttom 20% liquidity is what tells an investor how much model can support. If an investor’s account grows too high for the model, he needs to find a higher liquidity model: the model is no good for him/her anymore (DennyH help me out here, this has been discussed before )

Steve,

Give me a week to make sure all is ok. Currently if you launch a live hedge portfolio there’s no logic that deducts margin/carry costs.

All:

I think leveraged ETF's should be disclosed, not forbidden. My $0.02.

Bill

Marco, you said for R2G models proposed rule is:
For hedging with margin (long positions + long hedge on margin, or long positions + short hedge):

  • Leverage 1.0, Margin cost 1.5%, Maintenance Margin 35%.
  • Leverage 1.0 is for the main positions only. When a 100% short hedge is preset the leverage goes to 2.0, and carry costs are paid.

Leverage (L) of the main positions > 1.0 should be allowed in R2G as long as the Hedge Ratio (R) is adjusted accordingly, so that the the leverage for the combined positions never exceeds 2.0. The formula is L = 2/(R+1).
R%< > L
100< >1.00
90 < > 1.05
80 < > 1.11
70 < > 1.18
60 < > 1.25
50 < > 1.33
40 < > 1.43
30 < > 1.54
20 < > 1.67
10 < > 1.82

Additionally, it would be nice to have the option of using Cash only for the hedge. One could use 100% Cash then irrespective of what the leverage of the main positions is.

So,

I didn’t know much about availability and borrowing costs on stocks apart from large caps. Here are some quick numbers from just the past ten days:

  1. For top 1000 Mkt Cap with over $5MM Daily Tot (60), seems like good availability and can currently borrow most to all of them for 0.25% to 2%…except in severe short squeezes where you can see 8-10% annual rates.
  2. For AvgDailyTot(60) $2MM to $5MM. Costs range from 0.25% to 5%. In current environment.
  3. For $1MM to $2MM. Using only SP1500. Can’t always borrow. But usually can (at least in this calm environment). Costs can raise up over 10%, on stocks with hi SI. Not sure can accurately backtest models in this liquidity range. MArgin rates will spike and availability fall during big market crashes. (I think).

Pretty clear that the margin costs should be pegged to the liquidity in some way (like a variable margin cost formula). Would want to look back at 2008 and 2002 as well.

There are also capacity constraints on the lower end. Sometimes not enough shares to sell an R2G.

Data points. Where’d I get these numbers? Some current short costs to borrow stocks:

Model 1. (all at IB). These are all big stocks. My systems either force stock to be in top 1000 in market cap and doing over $5Million dollars a day in daily liquidity over past 60 days. Sometimes both.

  1. BBRY. Reached past 8%+ costs when short squeeze on. I was shorting.
  2. FNV. Currently 0.25%. Reached 1.46% when I was shorting last week.
  3. FMX. Current. 0.72%. A few hundred K in shares available.
  4. EW. Current. 0.25%. 2Million shares available.
  5. TRQ 0.47%. A few hundred thousand shares available.

What happens is…if there is a big short squeeze, borrowing costs go way up. I was in BBRY during this. Otherwise, these large, liquid stocks have a few hundred thousand shares available at low rates. Likely pegged to interest. You also have to pay the dividends on the underlying stock, but models handle that.

If I lower liquidity and look at shorting stocks between $5M DailyTot(60) and $2M daily tot (60) - I get stocks like -

  1. RIGL. 0.25%. OVer 5 million share available.
  2. PVG. 1.8% with 400,000 shares.
  3. SEA. 2.8%. Has been has high as 3% in past 10 days. Only 20,000 shares available.

So, borrowing costs re rising a lot without short squeezes in place. If a system is using high short interest to find shortable stocks, they are paying much more likely…as those rates are rising. Some stocks can’t be shorted.

If we go 1MM to 2MM liquidity, get the following:

  1. IMI. 0.35%, 500,000 shares.
  2. TAHO. 100,000 shares available. 0.43%
  3. TRX. No data available.
  4. UEC. No data available. Checked NYSE and Nasdq.

Now, it’s possible I’m not finding these because I’m in the All Fundamentals and these are foreign stocks on foreign exchanges.

So…I switch Universes to SP1500 with same low liquidity constraints.

  1. SIGM. On the Nasdaq for 0.25% Over 2,000,000 shares.
  2. NANO. 0.35%. Over a million shares.
  3. DEL. 0.25%, 250,000 shares.
  4. PQ. 0.25%. over 3,000,000 shares.
  5. HZO. 0.25%, over 2,000,000 shares.

Bottom line, stocks within SP1500 with AvgDailyTot(60) between $1MM and $2MM seem to be pretty avail. Would need to run samples on past dates to make sure. And under short squeezes. But appears workable.

Now, I look at the top 10% of companies with outstanding short interest. With the $1MM min. liquidity (up to anything).

  1. BKS. .627%. 200,000 shares available.
  2. SWC. 0.6%. 800,000 shares.
  3. AIRM. .052%. 250,000 shares.

So, even at these levels of shorting, seems that can be playing. Each model builder would need to run tests for at least 30 of their stocks over 5 different time frames, but appears we can short more than I first thought.

If I force the sim to look at only stocks with liquidity between 1Million and 2 Million Avg Daily 50 and top decile short interest, I get:

  1. RICN. Cost is over 10.8%. Only 25,000 shares.
  2. FBP. .655%. 100,000 shares.

So…in some cases, get huge spikes in costs.

Hi,
In the beta hedged module, I believe that I was able to run a sim so that the hedge was placed on margin, so no need to decrease positions. I’m not sure how to do that with the live version. Is this possible?

I don’t agree with excluding leveraged ETFs, they can be used effectively as a hedge. I agree they should be disclosed.

Don

Hi,
Is it possible to run a sim so that the hedge is placed on margin, and then the stock positions don’t need to be adjusted? I tried setting position tolerance to 50% but I’m still getting the same number of small decrease positions trades as I did with 5%.

My goal is to run a hedged sim where I only adjust the hedge, not all the stock positions.

Don