Hedging the VIX & More Stock of the Week
In truth, I’ve actually been trading the SOTW in two variations. The first is exactly as I described it in my review: buy at the Monday open and sell at the Friday close. The second is a hedged variation that uses index ETFs to reduce market exposure.
As the review showed, the SOTW has generated a lot of alpha, but because it’s a long-only equity program that’s always invested in the market it has also been subject to a lot of beta-risk. Put another way, when the market is performing poorly it’s dragged on returns (and vice-versa).
The graph above shows the hypothetical results of the original SOTW (blue) compared to a hedged variation (red) that’s more or less the same as the one I’ve been trading, versus the ETF SPY (grey) since inception.
In the hedged variation I’ve assumed a trader went long the SOTW each week at Monday’s open, but also (using leverage) shorted an equal dollar amount of the ETF SPY (to offset beta risk).
A couple of important notes:
1. I’m KISS’ing with the hedge. Really hedging beta would require looking at each week’s individual pick and then choosing the offsetting ETF and dollar amount that would be best in that specific circumstance. I don’t do that as part of the Play Money Project, because I’m trying to keep the workload to a minimum. Also note that in my own portfolio I go long RWM rather than short SPY, but more folks are familiar with SPY, so I’m using it here.
2. These results do not account for transaction costs or slippage because trading frictions are very specific to the individual trader. The average/median return per week was 1.52%/1.66%, so there’s quite a bit of meat to work with.
Numbers for the number lovers…
Thoughts on the Hedged Stock of the Week
The hedged variation has created a considerably smoother ride by better isolating just V&M’s stock picking skills. Correlation to the broader market has been near zero and risk-adjusted returns have been improved.
Two flies in the ointment:
1. The hedge creates additional transaction costs, something a smaller investor especially would need to consider.
2. The success of the original SOTW strategy required V&M to pick consistent winners, but the success of the hedged strategy requires V&M to pick consistent outperformers. Those are two entirely different things.
I think it’s a lot easier to pick outperformers in all market types (consider the difficulty, for example, of consistently picking long winners in a bear market), but when picks are flat/negative in a bull market (which has happened a bit this year) the hedge acts as a double-doozy on returns.
[click for a summary of all recent posts about the VIX & More SOTW]
P.S. again, I’m not compensated in any way for these posts – I’m just trying to shine the light on the good guys.
. . . . .
Filed under: Random Stuff | 9 Comments