Hedging; Are You Doing It Wrong?
Michael Venuto from Toroso sat for the Trillions podcast with Eric Balchunas and Todd Rosenbluth and the conversation was about different ways to hedge portfolios using ETFs. I'll recap some of the highlights and weigh in on my thoughts on the same types of products.
They started talking about VIX products and no one thought it was usable as a hedge because of how aggressive the contango erosion can be. The long VIX products can absolutely skyrocket but holding as a hedge you're essentially guessing when the VIX is going to jump. Another point I have made about these over the years is that technically, the VIX doesn't have to go up if the market declines. Yes, it almost certainly will rise when the market falls but it is not direct and absolute cause and effect. I always talk about how bear markets start slowly. What if the unusually narrow daily moves from all of 2017 were actually down instead of up, would the market have gone down, I don't know, 10-15% and VIX have actually dropped? The lack of predictability and lack of guarantee that the underlying will do what it is "supposed" to, plus the contango makes these very difficult to use.
The conversation then moved to inverse index funds. There are of course levered, inverse funds but this part of the conversation focused on the ProShares Short S&P 500 (SH). The drawback here, and it can be serious, is the sequence of returns of the S&P 500 while the fund is held. The wrong combination of up and down days can result in the fund not doing what a holder would hope it would do which is go up 10% if the S&P 500 goes down 10% over a specific period. Play around with SH versus SPDR S&P 500 (SPY) on Google Finance. The worst period I can find for SH not doing what someone might hope for as follows;
It was up 21% in a down 39% world in 2008. There was an issue back then with whether counterparties for the derivatives used would be in business to honor the contracts. I am not sure if that contributed to the numbers but it could have. Either way though, look at how it has done for every other time period and draw your own conclusion about how effective it might be in a hedging context the next time the market goes down a lot. To be crystal clear, the risk that the sequence of returns hurts the fund the next time the market goes down, remains, it doesn't go away. Using SH would mean understanding that drawback and being willing to take that risk.
They briefly touched on options ETFs but didn't seem to really dive in. There was a mention of the WisdomTree CBOE Putwrite ETF (PUTW). I have mentioned this fund a few times here and can't stress this enough, selling puts before a large decline is a very bad idea. That is not an attempt to call a top here, merely pointing out we are nine years into a bull market and while no one knows when it will turn, the pain caused by selling puts will be bad. I wrote about this several weeks before the recent correction and sure enough the fund offered no protection in the correction (down 8% in a down 9% world) and it won't offer protection the next time the market goes down a lot.
From there they moved on to hedge fund replicators. This is a favorite topic of mine for both the portfolio utility that I think can be added by using certain replicators and also because the funds themselves are interesting to learn about, even the ones that would make lousy hedges.
Venuto had a great quote about replicators, saying that this is what ETFs were made for, democratizing strategies. In this context he likes AGFiQ US Market Neutral Anti-Beta Fund (BTAL) which is a name I have mentioned a few times as being interesting for bear market protection but not to own during the bull phase. It was Venuto's appearance on ETFIQ on Bloomberg a couple of months ago that clued me in to BTAL.
I've written many times that I think merger arbitrage and managed futures can work as effective hedges in a bear market. Managed futures is tough because it has done poorly for just about this entire bull market and where the bull is so old it is difficult to find a time that it did well. Just because I think it would be effective doesn't mean it must be so but it is worth learning about if hedging with alternatives interests you.
One hedge fund strategy I would stay away from for hedging would be 130/30. This strategy uses leverage to go long 130% and short 30%. The shorts should not be expected to bail out the longs in a broad decline. This is an alpha-seeking, bull market strategy.
In the realm of alternatives, Venuto likes what JP Morgan is doing. It has four ETFs; It has a multi-strategy, event driven, managed futures and long short. Multi-strategy and event driven can work in this context but there is enough opacity that it can be difficult to understand exactly what a given fund in either segment is doing to seek the effect. The IQ Hedge Event-Driven Tracker ETF (QED) looks much different than the JP Morgan Event Driven (JPED). Both could do exactly what a investor would hope for in a bear market, neither one could or maybe just one of the two. I think that makes this slightly less reliable hedge and I would not use it.
The guys then moved on to talk about gold, I have owned GLD for clients since it first started trading in late 2004 (I think I actually bought it in early 2005). As they said there is no guarantee gold will work when you need it to but it works often enough for me to own it personally and for clients. Venuto likes the Credit Suisse Gold Shares Covered Call ETN (GLDI). It generates income from a gold holding which is potentially attractive, the added complexity of it being an ETN is a negative. Click through and look at the performance, it has been dreadful. If you want to use it, own it in an IRA and reinvest the dividends but I have no interest in owning this one. You could accomplish a very similar effect (income from a gold position) selling covered calls directly on GLD or IAU.
Venuto said he models his portfolio like the permanent portfolio which of course allocates 25% each to equities, long bonds, gold and cash. I did not take him to mean he literally builds a permanent portfolio but is merely influenced by it but I am not sure. Either way, that is interesting and I will explore it in a subsequent post.
They did not talk about sizing hedges in a portfolio. I've been saying this since before the last bear market. Keep the hedge sizing small, starting 2-3% per hedge vehicle maybe totaling 10% of the portfolio. The hedges will grow relative to the portfolio to hedge more long exposure as the market goes down more. With the uptrend still in place, I am nowhere near 10% in hedges now. I will increase slowly when my indicators trigger (SPX breaches its 200 dma, the yield curve inverts, the 2% rule comes into play). That kind of weighting combined with just a couple of sales can go a long way towards reducing a portfolio's correlation to the broad market which is exactly what you should want to do when the market starts to truly roll over.