unsung virtues of a dynamic hedge
I’ve recently been working-on and trading an equity strategy that has some great characteristics and some interesting challenges. The great characteristics revolve around its profitability, volatility and simplicity. The challenges start with the fact that the strategy generates alpha on the short side – thus, you are intrinsically swimming against the tide and can conceivably be ruined in a hurry. Your broker might also be unable to find inventory to short. Other challenges include the native capacity of the strategy – it’s not fundamentally scalable as a strategy and only a relatively small amount of money could be put against it without incurring increasingly onerous costs and risks. In any case, it’s been a fun strategy to develop as it’s an interesting puzzle and it makes money.
Discussing the strategy recently with a potential client, they observed that such a strategy wouldn’t be acceptable within their environment (apart the capacity issues) as their risk management practices required all strategies to maintain dollar neutrality – for any dollar of x that they used to buy something, they needed to sell a dollar of y. This led to an interesting experiment for me, the results of which I share with you below.
I wrote a simple, dynamic dollar-neutral hedging StratPart which would do as this trader had described: for any amount of money the strategy spent, the dynamic hedger would employ the same notional amount of money on the other side of the market on a specified instrument. Thus, configured to hedge with the SPY, it would buy $100K of SPY for any $100K my strategy sold. I say “notional” because if the StratPart is configured with a future, then it would buy the appropriate number of contracts based on the notional value of the futures position.
This was about the simplest imaginable StratPart and it didn’t take more than an hour to get it working. In spite of the simplicity of implementation, the results were surprising and, honestly, delightful. The below table characterizes the strategy’s performance in a few different configurations: the raw/unhedged strategy, hedged with the SPY, and hedged against ES (s&p emini future).
As I’d mentioned, the unhedged strategy is already quite nice. Adding the SPY hedge has a very nice effect in that you dampen both volatility and profitability, but in a positive ratio such that the resulting risk-adjusted behavior is better than the raw strategy. That said, the cost of the hedge is quite high and this limits the overall profitability quite substantially. The futures hedge addresses this with its lower costs. It maintains the profitability of the raw strategy while mixing-in the excellent volatility-adjusted performance of the hedge. These returns are calculated against historical data from 2003. The returns are *not* being reinvested. The below graph illustrates the NAV for each of these configurations assuming an initial cash position of $1M.
Clearly, this is a nice and cheap improvement to the base strategy. And there’s still clear room for improvement. One of the problems with this hedge is that the strategy itself is essentially uncorrelated with the S&P500. Thus, the hedge does a very suboptimal job of damping the strategy’s native volatility. A more correlated instrument or set of instruments would likely yield better results.
All the same, the results were very easy to implement within StratBox and pretty dramatically illustrate the unsung virtues of a dynamic hedge.