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I've followed some funds that employ active hedging strategies and they mostly underperform.

Here is a long short/fund as an example:
https://arrow-capital.com/sites/default/files/media/Curvature_Market_Neutral_Fund_Overview_-_F_class.pdf

It has underperformed the TSX on a 1, 3 and 5 year basis which is fairly spectacular.

I don't hedge and don't support such strategies. The best protection and the only free lunch is a well diversified portfolio. Diversify across economies, asset classes, sectors, etc. Don't try to predict the future and stay stoic.
 

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Discussion Starter #42
I agree that the only free lunch is diversification/asset allocation.

If you're willing to share, what's your asset allocation or breakdown? And to colour that, could you add whether you have some kind of pension separate from this AA?
 

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Likely not asking me (12 years into retirement), but an example. Setting aside 'one off' large purchases, exceeding $30k in any given year, my annuity income (DB/CPP) covers 1/3rd of my annual cash flow needs, and investment income the other 2/3rds. I tap into original assets for 'one off' large purchases.

The investment income comes from (current mix):
35% Canadian equities (all dividend payers across 5-6 sectors)
34% US equities (~95% broad based ETFs)
15% International equities (all broad based ETFs)
4% Preferred equities
7% GICs/Bonds
5% Cash (MMF/ISA - brokerage)

Percentages vary by a few percentage points year to year depending on how/where I tinker with a holding. I'd like to boost International equity at the expense of Canadian equity, but not at a 75 cent dollar.

Plus I have some HISA cash sitting in a few online bank accounts that I don't count. Rule of thumb overall... 85% equity, 15% fixed income (for black swan purposes).
 

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Changes to margin policies can also happen fast. How are you going to detect and respond to that? I like using margin for short term maneuvers but it's not a good idea for longer term positions. Unless you are going to be constantly on top of your brokerage for the next 20 years, and have enough cash on the sidelines to respond to margin policy changes, I seriously doubt this method will work.
^ this ...by any measure, 100% equities and buying on margin at what are assumed are market lows is a very high risk game ... plus even though bonds don't anti-correlate with equities, they do enough so that they could be a much more secure source of cash for buys at presumed market lows ..
 

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The commercial hedgers beat the pants off of the speculators. The 1929 crash is a very good example of what can happen to speculators that buy on margin the more margin they used the worse they did during the crash.
 

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Discussion Starter #46
This is pretty interesting. Apparently there is a "tail risk" ETF named TAIL. It holds S&P 500 index put options:
Cambria Tail Risk ETF (TAIL) | Cambria Funds

The MER is pretty low. It's quite a bit more straightforward than some of the more exotic derivative ETFs; it's not a "daily movement" kind of ETF, so there is no chronic price decay like you see on many of the typical inverse funds.

Instead they hold a ladder of index puts and continually roll them over. I think I would rather buy this and get the automatic rollovers and management, than tinker with options myself.

Maybe TAIL is a good way to get your "insurance"?

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Discussion Starter #47
More on the TAIL strategy, paraphrasing from a paywall protected article I found.

TAIL uses some general guidelines to select its put options. They hold S&P 500 puts ranging from 1 to 16 months. Strike prices are typically 5% to 15% out of the money. The active manager decides to sell or exercise them before expiration, attempting to avoid time decay.
 

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This is pretty interesting. Apparently there is a "tail risk" ETF named TAIL. It holds S&P 500 index put options:
Cambria Tail Risk ETF (TAIL) | Cambria Funds

The MER is pretty low. It's quite a bit more straightforward than some of the more exotic derivative ETFs; it's not a "daily movement" kind of ETF, so there is no chronic price decay like you see on many of the typical inverse funds.

Instead they hold a ladder of index puts and continually roll them over. I think I would rather buy this and get the automatic rollovers and management, than tinker with options myself.

Maybe TAIL is a good way to get your "insurance"?

View attachment 20255
Interesting concept. The chart kind of mirror the VIX movements. In the recent market crash it has gone up 25% from the lows in January, which approximates the market decline. It does not seem to have an uptrend, so one has to aggressively rebalance or trade it. There is a small downtrend at the end of 2019, when the market was making new highs.

If one does a 50/50 with stocks, the portfolio will be protected from severe losses (and no need for bonds), but overall returns could suffer if there are losses on the TAIL side. On the other hand, one could lever it up, given the downside is limited. The rebalancing bonus could be substantial.
 

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Discussion Starter #49
Interesting concept. The chart kind of mirror the VIX movements. In the recent market crash it has gone up 25% from the lows in January, which approximates the market decline. It does not seem to have an uptrend, so one has to aggressively rebalance or trade it. There is a small downtrend at the end of 2019, when the market was making new highs.
Yes, it's interesting that it mirrors VIX movements but more to the point, it correlates about perfectly with the S&P 500 itself which you can see in this chart against SPY.

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If one does a 50/50 with stocks, the portfolio will be protected from severe losses (and no need for bonds), but overall returns could suffer if there are losses on the TAIL side. On the other hand, one could lever it up, given the downside is limited. The rebalancing bonus could be substantial.
I don't think you'd want 50% TAIL 50% SPY as it would wipe out all your performance. I do agree that there would be a rebalancing bonus. Maybe an approach could be to carry a small weight in TAIL all the time, but strategically increase the weight when protection is desired?

A perfect example might be this February 19 post of mine: I was feeling very nervous about how stocks were going straight up, not ever correcting, with no volatility. That would have been a great time to add-on TAIL as insurance.

It seems to behave as we'd expect insurance to behave: slightly negative performance when the market is behaving well, but a sharp increase when the market has trouble. Not much historical data, though, so it's hard to tell how it might behave going forward.
 

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....I don't think you'd want 50% TAIL 50% SPY as it would wipe out all your performance. I do agree that there would be a rebalancing bonus.
The effect on performance would to an extent depend on how bad TAIL performs during a rising market. Given it is an option strategy, time decay, deltas, and volatility contraction will be headwinds. But it is unlikely that it would completely reverse SPY gains like a inverse ETF would, because of the limited loss aspect of long options.

Maybe an approach could be to carry a small weight in TAIL all the time, but strategically increase the weight when protection is desired?
It could work. The results would largely depend on where the funds are coming from (stocks, bonds or both).

Having a small weight could be a good trade, but I doubt it will have a major effect on the portfolio. As an example, an all stock portfolio of $100 would have lost $33 in the recent crash. A 90/10 with TAIL would have still lost $27. An improvement, but not a game changer. A 45/45/10 S/B/TAIL would have lost $12 vs $16.50 for a 50/50 (I just assumed bonds didn't move for simplicity). Not bad for such as small allocation.
 

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Discussion Starter #51
A 45/45/10 S/B/TAIL would have lost $12 vs $16.50 for a 50/50 (I just assumed bonds didn't move for simplicity). Not bad for such as small allocation.
Interesting. Or think of how many people hate bonds... maybe TAIL could somewhat replace them in an allocation as an alternative portfolio asset.

My initial sense is that TAIL might be most useful as strategic / add-on insurance. How many times have we seen an equity-heavy investor say that they like their equities, but are worried (or have a spidey sense) that stocks are going to crash.

I'll then say: how about a more conservative asset allocation?

And the response is usually -- no, I want equities, or I have unrealized cap gains that I don't want to trigger. I'm just worried about an imminent crash. Perhaps in these situations, TAIL (an insurance policy) could offer the kind of safety that is desired, without having to sell equities or refactor the asset allocation.

It may not boost their returns, but it certainly would nullify some of their equity volatility with very low effort, and that could be a "win".

Think of how Rusty and countless others on this board wanted to deploy new money into equities, convinced that they really want equities... but can't shake off the worry of an imminent crash. Why not have your cake and eat it too? Load up on equities, then add the insurance.
 

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CBOE has a few indices that it has been tracking for a few decades. One of them is PPUT, which is SPX plus a 5% OTM protection put. The CAGR from June 1986 up to July 2019 has been 7.09% as compared to 7.84% for SPX. SPTR (the total return index) returned 10.21%, but one would have received the dividends if bought SPY and protection puts. The volatility as measured by CV is comparable to SPX, but improved vis a vis SPTR (52 vs 59 vs 71).

I am not exactly sure what composition of SPY+TAIL would approximate PPUT, but I don't think it would be 50/50.

PPUT does not include frictional costs, which would be a factor in TAIL. It is also passively managed and buys monthly options, while TAIL can use longer dated ones.
 

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We had a thread recently about trading, in particular TQQQ. I think TAIL would be a more interesting trade, given that it is negatively correlated with stocks, VIX is generally range-bound, and we (and the whole world for that matter) is long stocks. At the time stocks are tanking in one's portfolio, those trades will shine. But is noteworthy that TAIL does not move as much as TQQQ.
 

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Discussion Starter #54
We had a thread recently about trading, in particular TQQQ. I think TAIL would be a more interesting trade, given that it is negatively correlated with stocks, VIX is generally range-bound, and we (and the whole world for that matter) is long stocks. At the time stocks are tanking in one's portfolio, those trades will shine.
That's a good point. If one can successfully time market movements (which we assume is possible, if anyone is bothering to trade at all) then there is more value added by trading something like TAIL.

Since we are all long stocks, being able to time the buys & sells on TAIL would be quite pleasant.

The question is, how well can you time the entry and exit from "a portfolio of index puts"?
 

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That's a good point. If one can successfully time market movements (which we assume is possible, if anyone is bothering to trade at all) then there is more value added by trading something like TAIL.

Since we are all long stocks, being able to time the buys & sells on TAIL would be quite pleasant.

The question is, how well can you time the entry and exit from "a portfolio of index puts"?
Not easy. But one measure could be the VIX. When the VIX is at is lowest, the market is making highs and at the same time option prices are at their lowest (in terms of volatility).


Eyeballing the chart, $20 would have been a good entry point. If one takes profits at 21 (5%), there would have been 5 or 6 opportunities to do so in the last 2 years. There were 2 occasions to take profits at 2, 3, and 4 dollars. Only one chance at $5% (25%).

As an insurance product, TAIL would have been most valuable during Dec '19 and recently in April '20. As a trading vehicle, I would go with the smaller, more frequent profits. This because 5-10% drops in the market happen more regularly than 20% plus crashes.
 

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Discussion Starter #56
As an insurance product, TAIL would have been most valuable during Dec '19 and recently in April '20. As a trading vehicle, I would go with the smaller, more frequent profits. This because 5-10% drops in the market happen more regularly than 20% plus crashes.
I agree with smaller and more frequent profits.

All of this made me curious, so I looked at my own proprietary indicator; it's my own "market strength" indicator. Just based on intuition, I guessed at a threshold at which to enter TAIL (when market is weakening) and another to exit (market is very weak / peak pessimism).

I then back-tested what would happen at these trading signals
2018-02-14 to 2018-04-06, TAIL +2.6%
2018-09-10 to 2018-10-22, TAIL +0.6%
2019-08-21 to 2019-09-06, TAIL -0.6%
2020-03-09 to 2020-03-18, TAIL +4.6%

This is just a first cut at a strategy using my indicator. If you look at SPY at each of those periods, you will see the overall improvement of TAIL vs SPY is actually pretty substantial.

In the recent March example, TAIL +4.6% while SPY -12.5%.

Since these are pretty quick entries & exit, I might look at the possibility of trading in and out of TAIL in my US margin account. So I could do this alongside my existing long positions.
 

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Good returns. The strategy could also be replicated buy direct OTM put options, unless one assumes that the managers would do a better job managing the portfolio or they would get better pricing.

As for a long term hold, if one could achieve a CAGR of 0% real on the TAIL side, then by upping the allocation to equities, one could reduce or eliminate the lagging effect of bonds on the total return.

Equity-like returns with bond-like volatility? hmm...that doesn't sound right...
 

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Discussion Starter #58
Good returns. The strategy could also be replicated buy direct OTM put options, unless one assumes that the managers would do a better job managing the portfolio or they would get better pricing.

As for a long term hold, if one could achieve a CAGR of 0% real on the TAIL side, then by upping the allocation to equities, one could reduce or eliminate the lagging effect of bonds on the total return.

Equity-like returns with bond-like volatility? hmm...that doesn't sound right...
I'm not yet convinced :)

There is limited historical data for TAIL so we're only really seeing it "at its best", with a steadily rising VIX and quite a few index drops. This is the right kind of environment for it.

If the market keeps acting as it has in the last couple years, then yes, there would be nice opportunities using SQQQ, SH, TAIL, TVIX, etc. But I'm also concerned with what happens in more normal market conditions, or strong multi year rallies.

To do a longer term back test, I would use a similarly behaving instrument such as SH and see how that worked out. Or maybe PPUT in case that is similar.
 

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I'm not yet convinced :)

There is limited historical data for TAIL so we're only really seeing it "at its best", with a steadily rising VIX and quite a few index drops. This is the right kind of environment for it.

If the market keeps acting as it has in the last couple years, then yes, there would be nice opportunities using SH, TAIL, TVIX, etc. But I'm also concerned with what happens in more normal market conditions, or strong multi year rallies.

To do a longer term back test, I would use a similarly behaving instrument such as SH and see how that worked out.
I agree with your point on limited data. I would like to see how much decay it has during a long term bull market similar to 2013. That would matter if one decides to hold it longer term.

I don't think SH will compare to TAIL, because by design SH should negate any movement of SPY on a daily basis. Holding both long term, would cancel SPY's returns and add a decay component from SH to it, resulting in a gradual loss.

If one takes daily movements as an example, a 1% up move in the SPY will be canceled by a 1% down move of SH. However, if one buys a put option for 100 shares of SPY, the change in option price will be less than 1% of SPY (depending on delta and vega), so the net result will be something like a 0.7% rise in the combo.

Combining SPY with TAIL would be like buy an ITM call option, with the added optionality of being able to decouple the trade at opportune occasions.
 

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Instead they hold a ladder of index puts and continually roll them over. I think I would rather buy this and get the automatic rollovers and management, than tinker with options myself.

Maybe TAIL is a good way to get your "insurance"?

View attachment 20255
Tail had very poor performance for holding put options during the crash probably from the roll over. Handsome profits would have been made on the puts bought before the crash & when sold during the crash though buying new put option for the roll over when premiums were high would put a drag on the fund.

I would stay away from ETF the reward was peanuts during the crash. If your going to risk money the reward should be bigger then the risk since everything on the table can be lost.

Though the loss from the beginning of the chart to Feb just before the crash was very small for being long put options.
 
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