This market environment is enough to put any dynamically hedged strategy through its paces. Ours have performed well in this environment but because of all the excitement the past couple of months, we’ve been getting a lot of questions about whether our dynamic hedge trigger rule is set to the right sensitivity level.
If you recall, our current dynamic hedge rule looks for the trigger at each month end only. So if the market closes below its 200 day moving average mid-month, the trigger is not pulled until it also closes below the threshold at the end of the month. In other words, we’re using monthly sensitivity on the trigger.
But why use monthy? Why not use “daily” sensitivity instead? Set to “daily”, we’d pull the trigger on any day the market index closes below its 200 day moving average, regardless of where during the month that happened. We’d pull the trigger again and remove the hedge on any day the index closes above its average and so on.
With monthly sensitivity, you avoid being whipsawed between being hedged and long only but with daily sensitivity, you remove the “arbitrary-ness” of the month end rule and you allow the strategy to react more quickly. If you really want to get customized, why not set the hedge trigger to daily when moving from long-to-hedged allocations and then reevaluate at month end to see if the index is still below its average. This “hybrid” approach combines daily and monthly sensitivities allowing you to be quick on the draw when hedging but aviod some of the whipsawing when the index wants to oscillate above/below its average. Which is better?
The graph above shows total returns using each of the three sensitivity settings on a portfolio that is 100% long the S&P500 when the trigger is off and 50% long / 50% short the S&P 500 when the trigger is on. As you can see its not even a contest, monthly sensitivity is by far the superior approach. But why? Our guess is that since markets have a long bias, over time you want the strategy that mimimizes the number of days hedged while still being hedged often enough to avoid protracted market contractions (see table). We’d love to hear other people’s point of view.
Total Returns By Trigger Sensitivity
| Sensitivity>> | Hybrid | Monthly | Daily |
| Avg/mo | 0.01% | 0.02% | 0.00% |
| 1year | 2.85% | 1.62% | -1.37% |
| 3year | 14.28% | 26.57% | 16.09% |
| 5year | 13.73% | 45.84% | 12.50% |
| Since 2000 | 15.40% | 82.89% | 8.09% |
| Days hedged | 1464 | 1191 | 1246 |
