Benefits of Hedging a Portfolio

Last week I discussed SPA3 risk profiles and the differing effects that each have on overall portfolio performance. This week I’d like to discuss the benefits of using a hedging strategy to offset potential losses from a long only, medium-term equity trading strategy such as SPA3.

When I set about designing and developing the SPA3 system which was first released to our customers in August 1998, my #1 criterion was to develop a strategy that would provide the user with an EDGE under all market conditions. This has not changed and although SPA3 has been improved over time the principles and signals of the strategy remain the same bar the addition of one signal in 2004.

From 1998 until November 2008, SPA3 has only been an investment strategy for buying stocks. It has contained no short selling strategy. With a 53% retracement in the market index and drawdown in the SPA3 public portfolio hitting as high as 32.51% it has justified the devising of a low correlated shorting strategy that would be executed during SPA3 high market risk periods. Furthermore, to trade through such a phase in the market and not make a change to a trading methodology that can improve its execution and performance in the future, would be irresponsible and naïve for a systems research company. My aim was to introduce a hedging strategy where SPA3 users would short-sell an ASX200 CFD when a SPA3 high-market risk signal occurs. The hedge would be put in place to reduce drawdown in a falling market.

It must be said that eliminating drawdown so that the portfolio makes money under all market conditions is extremely challenging. My aim was to have portfolios tread water in a falling market and then maximise the returns that can be made through medium-term trading equities when the market starts to move in an upward trend again.

I have placed the two equity curves of the two strategies below. Figure 1 shows the unhedged long-only SPA3 public portfolio from January 2001 to the present. It has traded through September 11, 2001, the 2002-2003 bear market where a 20% retracement occurred in the index, and the recent bear market.

FIGURE 1. SPA3 Long only – no hedging strategy

When looking at the performance of any portfolio it is important that you firstly have a large sample of trades in differing market conditions. This portfolio has just that. The blue line is a marked-to-market equity curve of the portfolio and the black line is the All Ords index. You will notice that the out-performance over 7 years and 10 months is $226,980 starting with a $100,000 portfolio.

Typically, SPA3 portfolio’s have achieved half to two thirds of the drawdown of that of the All Ords in a falling market and have achieved around double the rise in a rising market, depending on portfolio size. You will also notice the portfolio’s equity curve is similar in shape to the All Ords as this portfolio trades stocks long only.

I know that a 53% retractment in the index affects SPA3 portfolios negatively even though they have out-performed the index. However, performance could be improved by further reducing drawdown.

Figure 2 shows the results of the SPA3 public portfolio including the SPA3 hEdge strategy. It has been run over the same period with the exact same long positions in place. The only difference is that the SPA3 hEdge trades have been added to the portfolio. Comparing the two equity curves in Figure 2 you will now notice that when the market falls and rises sharply the hedging strategy kicks into play causing the portfolio equity curve to inversely mirror the All Ords index.

FIGURE 2. SPA3 with hedging strategy

There maybe times in a bull market when the hedging strategy will give money back to the market because of small ‘false’ high-risk markets happening along the way. This is a lot more manageable, as investors struggle considerably more with drawdown than not making as much on the way up.

From the SPA3 equity curve performance in Figure 2, it is clear that the results of employing the hedging strategy far outweigh not using it. By simply short-selling index CFDs when a high market risk signal occurs, we have actually been able to eliminate drawdown during this bear market whilst at the same time remaining committed to our long-only equity portfolio although at greatly reduced exposure.

Figure 3 lists the hedge trades over the life of the portfolio. Please make note that in 7 years and 10 months the portfolio has been hedged a total of 36 times. There have been 22 loss trades totaling $84,057 and 14 winning trades totaling $240,528, this makes the winning trades 2.861 larger than the losing trades. This is an edge. The hedge position sizing is calculated mechanically using the SPA3 portfolio manager.

FIGURE 3. SPA3 HEDGE TRADES

What the charts are unable to show are the psychological benefits of employing a hedging strategy. The charts can’t show the sleepless nights and periods of intense worry and stress experienced by those traders hanging onto “quality” stocks during these rough times and watching their portfolios lose value day after day as the market fell sharply from its dizzy heights.

For long-term investors with a long only view of the market, and for those unable or unwilling to use short selling of equities or derivatives in their trading, the use of a hedging strategy adds security to your portfolio. It ensures that portfolios can be maintained, dividends still received, and long trades still entered, even though the market is falling, as the value of the portfolio can be offset by hedging. You will still need market market-generated trigger or signal as to when to and when not to hedge. This is imperative as in a rising market you will give it back plus more if the hedge is left in place. In a fast-falling market, such as the one we have recently experienced, it can also actually result in hedging profits being generated – a nice bonus!