New R2G - To hedge or not?

I am getting close to launching my first a R2Go model, but struggling with the hedging question.
The strategy holds 20 liquid stocks at all times across all sectors, mostly mid-cap exposure with low turnover and long holding periods.
The sim produces about 35% annuals with a reasonable sharp during the past 15 years, a little over 40% for the hedged version with a 1.7 Sharp (includes variable slippage). The hedge is based on the SPEPSQ and looks great on paper, however it has only been activated a couple of times in the past, so I feel like there is not enough data to make it statistically relevant. I have been in this business for about 20 years on a professional level and used many different strategy development software in the past, but fairly new to P123, so I was wondering what thoughts you guys have on using a hedge???

Thanks

Ben…

Hi Ben:

Like you I don’t have much confidence in hedging or market timing systems that have only a few data points. Even so, I use market timing, but I always ensure my systems “work OK” with the timing turned off. My expectation is that the timer will work some to some degree but that it will also fail sometimes in the future.

To ensure that I’m able to financially (and emotional) survive any drawdown that might come, I limit my trading capital exposure to no more than 1/3 of my net worth. Further, I limit my exposure to any one stock to a maximum of 5% of my trading capital (less than 2% of net worth). Everyone’s situation is different so my numbers may not be appropriate for you.

The key, for me at least, is keeping greed from leading me to commit more than my risk tolerance.

Best regards,
Brian

Ben,

for me a hedge has to be on always, and is for people who do not trust their own strategies.

“The hedge is based on the SPEPSQ…”
What you do is market timing, including a little known portion of curve fitting.

What is the max. DD with / without “hedging”?

Matthias

Hi Ben,

I do not hedge out of principle. P123 gives you the ability to build a strong system using the ranking system. Factors in the ranking system can be adjusted and they will always work. Hedging relies on market timing, and we are fooled into thinking that we can time the market by looking at the past.

So in your case I would rather focus on getting the ranking system right with factors that are working under any market conditions. This will result in a simulation with steady capital curve (ie. steady returns), which a subscriber is ultimately interested in.

53% max DD with no market timing. Doesn’t mean it will happen in the future, but still a tough number to swallow. Don’t really see a way to stay 100% invested with a realistic and diversified portfolio without some suffering along the way.

I don’t think hedging should be all all or nothing proposition. Sure, you can argue about lack of data points etc, but there are lots of different ways to hedge and it would be a big move to have one hedging position, on or off, that is supposed to protect everything you own.
The question was however, about hedging an individual R2GO. That really is asking, what will subscribers think? I can tell you no one likes to lose 50%+. And using a hedge is different to selling everything. if you have positive alpha and the hedge is deployed, what is the worst that is going to happen?

I stopped hedging or market timing. However, I think the fact that it was triggered only 2 times in the past would be a plus–if I were going to hedge or market time.

My thinking is that hedging is meant to reduce a large drawdown only. While not going off too often may reduce the likelihood of saving me in bad market times, it is less likely to harm my returns in the future.

So a hedge that goes off only a few times gives me a (possibly false) sense of security without harming my returns too much.

No hedging is better still.

But don’t go by me. I do not subscribe to R2G ports.

I love the idea of hedging and would absolutely positively do it . . . IF I had a timing model in which I felt comfortable going forward. But I don’t, not even close. Sniff,sniff.

The timing models people on p123 seems to be using are the ones that depend on the trends in SP 500 eps estimates, and we’ve seen that they worked pretty well in 2001 and 2008. But they failed badly in the quick but painful drawdown period we had in 2011 because that was driven entirely by news, not by anything the data picked up (I tried to models a technical thing, but that really isn’t my comfort zone so I have so far been unsuccessful). We also have to keep in mind that the next major market crisis is likely to relate to increase sin interest rates, We don’t have anything on that in our database. So for that reason, I’m not using a timing system with any model I use for real money investing.

I would if I could but I can’t so I don’t. :frowning:

The problem I have with hedging is many of the R2G systems use bonds as hedges. They have worked in backtesting because we have had 20 year bull market in bonds. Well how much higher can bonds go? My guess if we have an “event” bonds and stocks will go down in in tandem at least until stocks normalize. I don’t think bonds will protect you. Even ones that are active all the time. Even the “Bond Guru” Bill Gross says the bond “supercycle” is over. I think going forward we should expect our returns to be much less than in the past. Andreas said what I think, cash is the best hedge.

I am looking for systems that take them selves out of the market by finding fewer stockst that fit the system parameters as the market gets toppy. I have at least one ten stock system that is holding one stock at present. I won’t speculate on what that means. It is not the most profitable system I have but I don’t worry about it as much.

George

I too am convinced that optimizing earnings based market timing based on the past two bear markets is not relevant. We are not expecting the next bear market to be caused by a financial crisis. We also don’t see a bubble in large caps yet. So the 2008 and 2001 data points are not very relevant.

Having said that, I do have confidence that hedging using earnings will “work” going forward for large cap systems over the next thirty years or so. It will win some and lose some but because many large caps bear markets over the past century were correlated with declining earnings it should work to a degree.

The earnings model was designed post 2008 but was never yet tested on large caps. In 2011 large caps never entered a bear market, and indeed the 2011 pullback in large caps was not based on fundamentals. That may be why it recovered so fast.

Ben’s question is one that many designers have. Do you add hedging to look good or stick to what you’re good at? By presenting R2Gs with hedging turned on it incentivizes designers to add hedging just to make the R2G look good compared to others that may or may not be designed to work in the future.

The solution is not simple. Just eliminating hedging from the R2G presentation can help but then timing can be inserted into the ranking rules. So what is the solution for R2G presentation?

Is it really that hard to time? Be in cash when the market is not in an uptrend and be Long with your Modell when the market is.

When I use a simple 200 MA Crossover System (Major Indexes below) and then go into cash (and go back into stocks when above) my Systems
that I use do have a much better mdd then without any Timing (50-60 without, 25-35% with that simple Timing).

I never hedge (other then with cash) or go short because if you are wrong you get a double whammy then instead of just not making Money (wrong hedge Instrument like bonds if they start to behave different then the last 20 years, etf Provider gets out of Business,
going short, market going up: instead of not making Money you suddenly loose Money etc.).

Im my Dissertation I combined a big cap momentum System (got one r2g like it) with a pretty simple formula:

When the 8 sma of the index is crossing under (or over) a combination of the sum of the index of SMA 5 + SMA 25 + SMA 40 + SMA 65
(e.g. result is an oscilator) go to cash (go Long in the Modell stocks).

I tested it from 1989 - 2003 with good results. I will try to implement this here and post the results in the out of sample time from
2003 - 2015.

It comes down using a purely bottom-up approach or a combo of top-down and bottom-up, which is what I am leaning towards. I used to work for a quant hedge fund where we used an overlay to hedge out exposure during certain vulnerable times determined by our chaos mathematics based timing tool. I will probably do something similar, so basically when the timing signal indicates rough waters ahead I would remain 100% long and use margin (35%) to add an overlay. We used futures, but for the sake of simplicity I will use the SPXU in proportionate allocation. Like that if the signal is a false positive the strategy should still make money based on the relative out performance of the longs vs the S&P, it also keeps turnover low and is tax beneficial. If you think a storm is coming why not prepare for it? just because you bought some canned food and water doesn’t mean it was a bad idea. Btw my goal with p123 is not really to maximize the amount of subscribers, but to generate a track record and turn it into a fund down the line, which is why having a small and illiquid strategy that is turned over every week is not an option.

Ben…