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**Risk Management using Timed Hedging**

Posted on January 30, 2014 by fgrossmannAs you perhaps know I have invested all my money in my own strategies, and I and my family (the best wife of all and 4 nice children) are living from the return of these investments. So, I just cannot afford to lose much money in market corrections. Therefore I always try to improve the strategies to lower the risk of major losses.

The new “Timed hedging” is a major improvement of the rotation strategies. It increases the Return to Risk ratio of all strategies a lot. Timed hedging allows you to reduce the downside risk or the volatility of your investment by about 1/3rd without affecting the performance of the strategies.

An excellent way to reduce the volatility or risk of your investment is hedging with Treasuries. Treasuries are most of the time negatively correlated to the stock market and still have a long term positive return. In my strategy emails, I will from now on always give an indication on how you can hedge the current strategy investment.

There is a good possibility that 2014 will be a more choppy market than 2013. The 32% performance of the US stock market is just crying for some corrections, even if the economy outlook is still very positive.

In a normal year like 2012 without tapering, the stock market (MDY – orange) and Treasuries (EDV – blue) have nearly perfectly mirrored charts.

2013 was a special year with extremely fast rising treasury yields during the summer period. This had the effect, that long duration ETFs like EDV lost up to 20% for the whole year. Since the beginning of 2014 treasuries show again a normal negative correlation of about -0.5 to the stock market (SPY).

Since hedging with Treasuries is an extremely simple and effective way to reduce volatility I have added a hedging proposal to all my rotation strategies (except the Bond Rotation Strategy).

To show you the effect of hedging, here is a backtest of the S&P 400 midcap ETF MDY hedged with long duration Treasuries. The hedged portfolio is composed by an 80% MDY long and 20% TMV short position.

The green chart is the hedged MDY portfolio and the blue chart is the MDY only portfolio. You immediately see, that the volatility of the green chart is very much reduced. The Return to risk ratio goes up from 0.71 to 1.32 and the maximum drawdown is reduced from 26% to 12%. But there is not only reduced volatility, but also a much higher return of 70% compared to 47% for the non-hedged portfolio.

So in this case, even with the negative effect of tapering in 2013 which can be seen in the chart, it is absolutely clear, that hedging would have been very good for such a portfolio. In my strategy emails, I will however not always advise to hedge, but I will try to time the hedging, so that such drawdowns like in June-July 2013 should not happen.

In order to hedge a portfolio, the best is to use long duration Treasury ETFs like EDV, because they make bigger moves. You can use EDV to hedge, but I prefer to short TMV. TMV is an inverse -3x leveraged +20 year duration ETF. If you short TMV, then you again have something like a positive acting +3x leveraged ETF.

I don’t like at all inverse stock market ETFs like SH as a hedge. Even worse are VIX ETFs like VXX. They both have very strong long term down trends. SH, the inverse S&P 500 ETF had a -15% down trend, and VXX a nearly -54% down trend during the last 3 years. Such strong down trends will wipe out most of the profits of your portfolio. Long duration Treasuries however make long term profits even with tapering.

There are several reasons, shorting TMV is the much better hedge then just buying a normal +20 year Treasury like TLT or EDV.

The most interesting reason is the huge time decay TMV shows. If you look at the chart below, then you see the blue chart which shows EDV for the last 7 month. The performance is nearly zero (-0.42%). It is the same for TLT for this time period. TMV however has a -12% performance due to the huge time decay which results of the continuous rebalancing. Now, the nice thing is, that if you short TMV, this -12% loss turns into a +12% gain. This gain adds to the normal positive yield of long term Treasuries.

Another reason to use TMV is, that it is bad to use too much of your capital as a hedge, because normally you do not make money with the hedge, but with the other part of your investment. Here a 20% investment in TMV is sufficient to provide a good hedge. You have 80% left for your normal investment which may be a stock market ETF like MDY or even an inverse volatility ETF like ZIV.

I like also TMV, because it does not pay dividends, so you do also not need to pay taxes on these dividends.

If you cannot short TMV, you may buy TMF the +3x leveraged +20 years Treasury ETF or EDV to hedge your portfolio. Here you see the same backtest with portfolio composed of 80% MDY and 20% EDV. It is also much better than a 100% portfolio, but TMV just gives you stronger hedging and a better performance at the same 20% portfolio weight.

Looking at our strategy rankings, you see that even with ongoing tapering, Treasuries had a strong comeback. They are again in the top ranks of our strategy ratings and the correlation to the S&P 500 index, which I show also in my ranking tables is negative again.

Examples on how to invest:

You see that as long as you hedge, you always keep 20% of your capital in a short position of the -3x leveraged TMV Treasury. Timed hedge means that you stop hedging if the correlation of Treasuries to the stock market (SPY) gets positive.

To show you the effect of hedging, here is the January FEZ chart with the current market correction (blue) and the chart of the hedged portfolio (80% FEZ + 20% TMV short). The effect of the hedge is easy to see.

I consider this additional timed hedging as a major improvement of the strategies, but after all, you are free to decide if you want to hedge or not. All the strategies should also provide good positive long term returns without hedging. However you may sleep better with less volatility in your investments.

Frank Grossmann

http://www.logical-invest.com

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