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How to Link an Existing Interactive Brokers Account
Posted in Account on 2017-12-05

If you already have an account with Interactive Brokers, linking up to Hedgewise is fairly simple. To begin, IB offers two interfaces for Account Management: "New" and "Classic".

Click the image below that looks more like your home screen, and you will be directed to the correct guide.

New Account Management

Classic Account Management

Interactive Brokers Disclosure

Interactive Brokers LLC is a registered Broker-Dealer, Futures Commission Merchant and Forex Dealer Member, regulated by the U.S. Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA), and is a member of the Financial Industry Regulatory Authority (FINRA) and several other self-regulatory organizations. Interactive Brokers is not affiliated with and does not endorse or recommend any introducing brokers or financial advisors, including Hedgewise Inc. Interactive Brokers provides execution and clearing services to customers of Hedgewise Inc. For more information regarding Interactive Brokers, please visit www.interactivebrokers.com.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

How to Link an Existing Interactive Brokers Account - New AM
Posted in Account on 2017-12-05

Step 1: Check Your Financial Information

Regulations require you to confirm the trading goals and investing experience of Hedgewise acting as your advisor.

1) Log-in to Interactive Brokers and navigate to Settings -> Account Settings -> Financial Information.

2) Update your Investment Objectives to be "Growth", "Hedging", and "Trading Profits". Indicate your Investment Experience in Stocks and Options as >10 Years, >100 Trades Per Year, and Extensive Knowledge.

3) Press "Continue" and confirm any remaining steps. If you needed to change this information, you may have to wait 24 hours for this change to be processed before continuing to Step 2.

Step 2: Check your Account Type

Hedgewise requires the use of a 'margin' account, which helps avoid trading delays due to settlement procedures and gives you the ability to trade options contracts as needed. To check and/or change your account type, follow these instructions:

1) Navigate to Settings -> Account Settings -> Account Type.

2) Set your Account Type as either "Margin" or "Reg T Margin". If you also need to change your trading permissions, select "Yes" below Account Type and proceed to Part 2 of Step 3. Otherwise, select "No".

3) Press "Continue" and confirm any remaining steps to upgrade your account.

Step 3: Check Your Trading Permissions

Your account trading permissions must match those of Hedgewise for regulatory reasons.

1) Log-in to Interactive Brokers and navigate to Settings -> Account Settings -> Trading Permissions (near the bottom of the screen).

2) Select "Stocks - United States" and "Options - United States." Press Continue.

3) On the following screen, you may be asked to indicate your experience with these products. Choose >10 Years Trading, >100 Trades Per Year, and Extensive Knowledge. This reflects the experience of Hedgewise as your advisor.

Step 3: Link Account to Hedgewise

Note that this step is not necessary if you set-up your account through an e-mail invitation from Hedgewise. You will also not be able to link any account that is already managed by another advisor.

1) Navigate to Settings -> Account Settings. In the Configuration panel on the right side of the screen, click the icon next to Create, Move, Link, or Partition an Account.

2) Select the radio button next to Move my Entire Account to an Account Managed by an Advisor or Broker, and then click Continue.

3) Enter our Advisor Identification information as follows:

Account ID: F1415661

Account Title: Hedgewise Inc

4) Click Continue and complete the remaining forms.

Interactive Brokers Disclosure

Interactive Brokers LLC is a registered Broker-Dealer, Futures Commission Merchant and Forex Dealer Member, regulated by the U.S. Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA), and is a member of the Financial Industry Regulatory Authority (FINRA) and several other self-regulatory organizations. Interactive Brokers is not affiliated with and does not endorse or recommend any introducing brokers or financial advisors, including Hedgewise Inc. Interactive Brokers provides execution and clearing services to customers of Hedgewise Inc. For more information regarding Interactive Brokers, please visit www.interactivebrokers.com.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

How to Link an Existing Interactive Brokers Account - Classic AM
Posted in Account on 2017-12-05

Step 1: Check Your Financial Information

Regulations require you to confirm the trading goals and investing experience of Hedgewise acting as your advisor.

1) Log-in to Interactive Brokers and navigate to Manage Account -> Account Information -> Details -> Financial Information.

2) Update your Investment Objectives to be "Growth", "Hedging", and "Trading Profits". Indicate your Investment Experience in Stocks and Options as >10 Years, >100 Trades Per Year, and Extensive Knowledge.

3) Press "Continue" and confirm any remaining steps. If you needed to change this information, you may have to wait 24 hours for this change to be processed before continuing to Step 2.

Step 2: Check your Account Type

Hedgewise requires the use of a 'margin' account, which helps avoid trading delays due to settlement procedures and gives you the ability to trade options contracts as needed. To check and/or change your account type, follow these instructions:

Log-in to Interactive Brokers and navigate to Manage Account -> Settings -> Configure Account -> Account Type. Make sure your account type is labeled either "Margin" or "Reg T Margin".

Navigate to your Account Type

Set your Account Type as either "Margin" or "Reg T Margin".

Confirm any remaining steps to upgrade your account.

Step 3: Check Your Trading Permissions

Your account trading permissions must match those of Hedgewise for regulatory reasons.

Log into Account Management and select Manage Account -> Trade Configuration -> Permissions.

You will be presented with a matrix listing the product types offered (e.g., stocks, bonds, options, futures, etc.) along with the countries in which trading in those products is offered. Make sure that only "US - Stocks" and "US - Options" are selected.

On the following screen, you may be asked to indicate your experience with these products. Choose >10 Years Trading, >100 Trades Per Year, and Extensive Knowledge. This reflects the experience of Hedgewise as your advisor.

Step 4: Link Account to Hedgewise

Note that this step is not necessary if you set-up your account through an e-mail invitation from Hedgewise. You will also not be able to link any account that is already managed by another advisor.

On the top menu, navigate to Manage Account -> Add or Link Accounts -> Advisor/Broker Account Setup.

Select Move my entire account to an account managed by the Advisor/Broker identified below.

Enter our Advisor Identification information as follows:

Account ID: F1415661

Account Title: Hedgewise Inc

Your personal Hedgewise advisor will confirm your account linkage request within 24 hours. Account links are processed every Friday. Typically the first trades in your account will happen the following week, or as soon as your funds clear.

Interactive Brokers Disclosure

Interactive Brokers LLC is a registered Broker-Dealer, Futures Commission Merchant and Forex Dealer Member, regulated by the U.S. Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA), and is a member of the Financial Industry Regulatory Authority (FINRA) and several other self-regulatory organizations. Interactive Brokers is not affiliated with and does not endorse or recommend any introducing brokers or financial advisors, including Hedgewise Inc. Interactive Brokers provides execution and clearing services to customers of Hedgewise Inc. For more information regarding Interactive Brokers, please visit www.interactivebrokers.com.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Analyzing Hedgewise 2017 Performance: Benchmarks, Timeframes, Theory and Proof
Posted in Investment Strategy on 2017-11-21

Summary

  • Hedgewise continues to outperform all asset classes and comparable benchmarks in 2017, achieving a return of 18% to 20% in products at higher risk levels.
  • However, many clients ask about how to evaluate this performance compared to the equity bull market, and wonder whether high returns this year foreshadow inevitable losses.
  • The most useful metrics actually have little to do with raw returns over the past day, month, or even year. The S&P 500 is often a poor benchmark to use, and recent positive returns have almost no predictive value.
  • While these facts can feel counterintuitive, a deeper analysis reveals that they are entirely consistent with the underlying financial theory, and help to paint a very optimistic picture moving into 2018.

2017: A Great But Unsurprising Year

Traditionally, portfolio managers are judged by the two most intuitive benchmarks: absolute performance and performance compared to the S&P 500. It is also quite natural to focus on recent history, so year-to-date figures tend to dominate. By these simple measures, 2017 has been a tremendous year for Hedgewise, which has achieved returns near 20% and consistently outperformed the S&P 500 (in Hedgewise products at a comparable level of risk).

Yet these benchmarks play almost no role in my internal analysis. Returns have been in line with my expectations, but I place little weight on where they fall relative to the S&P or the somewhat arbitrary YTD figure. While 2017 has provided a few more data points that suggest markets continue to function as the theory might predict, I'd be equally pleased with a year of flat or even negative performance so long as it validated the same.

As an example, I was quite excited to see how Hedgewise products mitigated losses during the bond pullback late in 2016, though clients were also experiencing losses along the way. I would describe that period of loss as necessary, expected, and a very positive indicator that 2017 might continue to unfold the way it has. Hedgewise pared similar losses in the energy markets earlier this year, which was a more important development to me than the fact that YTD total returns were positive at the time.

While on first glance such a perspective may seem strange, it is actually quite intuitive once you examine the underlying principles at work. It can also be fairly transformative for your investing mindset, reducing the burden of worry about bubbles, relative performance, and manager acumen. Below, I've examined the key ideas that shed light on why traditional benchmarks and timeframes don't apply, how this relates to the core financial theory, and where this year's performance fits into the picture.

But first, let's take a quick look at what happened so far in 2017.

Performance Recap: Hedgewise Outperforming Where It Should

So far in 2017, Hedgewise products have outperformed all traditional benchmarks at comparable levels of risk.

Hedgewise YTD Performance vs. Traditional Portfolio Benchmarks

ProductYTDBenchmark (Ticker)
RP+ Med.10.04%6.80% (AOK)
RP+ High12.81%8.44% (AOM)
RP+ Max18.70%15.17% (AOA)
Mom. Max20.57%17.36% (SPY)
Data as of November 17th, 2017. Hedgewise performance based on a composite of all live client portfolios in each product and include all costs and fees. Benchmarks based on publicly available end-of-day prices and include all dividends.

As I discussed in the intro, while this outperformance is broadly in line with expectations, it is not all that meaningful over such a short timeframe. I'd be equally pleased if Hedgewise had simply matched the benchmarks or even underperformed because neither stocks nor bonds have experienced any persistent downswing this year. Regardless, the big picture is that Hedgewise continues to prove that you can successfully manage major risks and still keep up with robust bull markets.

Hedgewise has also consistently matched or beaten the other major Risk Parity mutual funds this year.

Hedgewise YTD Risk Parity Performance vs. Major Mutual Funds

Hedgewise data based on composite client performance at each risk level and includes all costs and fees. Mutual fund data based on publicly available end-of-day prices and includes all dividends. As of November 17th, 2017.

I love this chart because it continues to validate the passive, systematic approach of Hedgewise. The AQR fund has about 300 holdings, invests globally, and employs five full time investment professionals. The Invesco fund takes a heavily active approach, often trading daily and heavily tilting towards certain asset classes. Both funds have an expense ratio over 1% and a significant tax burden. Hedgewise has a maximum of seven holdings, invests solely in the US, and runs entirely via tax-efficient algorithms at half the cost. As you can see, all of that extra complexity and expense doesn't add up to much!

Risk Parity strategies as a whole have done well in 2017 for a simple reason: stocks, bonds, and commodities have all gone up. Momentum has done even better since it overweights stocks, which have performed the best. In some ways, that makes this year relatively uneventful, since there's not much opportunity to demonstrate the use of hedging and risk management. However, it does help to dispel the common misconceptions that bonds will be a drag on portfolios during bull markets or that hedging in general must depress returns (ideas which I've covered in greater depth in this article).

Still, most clients find it strange that I'd call a year of 20% returns uneventful, and stranger still that I'm not worried about an equity pullback, that I don't closely follow this month's returns, or that I'd call a 10% drawdown no big deal. But allow me to explain, and you'll see that these ideas are both simple and cause for persistent optimism.

Benchmarks: Moving Past Absolute and Relative Returns

Traditionally, bull markets are celebrated and managers are rewarded for beating common benchmarks like the S&P 500. At Hedgewise, I view positive returns as commonplace and I expect to underperform the S&P 500 quite frequently.

The key to understanding this is all about stability. The goal of any good risk-managed framework is to produce more consistent returns, which means I'd rather have two years of 5% returns than one year where I make 20% and the next where I lose 15%. This is because such volatility inevitably injects timing risk to a portfolio - what if you happen to start at the wrong time, or what if you can avoid the next downswing? In real life, you also run into unfortunate stretches like 2000 to 2010 where a couple of bad years can wipe out a decade's worth of gains.

Hedgewise seeks to create stability through a variety of hedging mechanisms, like intelligent diversification, risk-weighting, and loss management. The goal of these techniques is to transform client return distributions to be more stable and consistently positive, like this:

Normal vs. Risk-Managed Return Distribution, In Theory

Note that the risk-managed curve experiences fewer extreme gains as well as fewer extreme losses, which is entirely the point! If the S&P 500 represents "Normal Returns", then that means you'd expect a risk-managed framework to underperform the S&P 500 when it is doing well and to outperform it when it is doing poorly. You would view both outcomes as equally good, since they both lend proof to the idea that returns are being stabilized.

By extension, you would only tend to see net outperformance for the risk-managed framework after the S&P experiences a period of underperformance.

With this in mind, let's see what this curve looks like for the actual Hedgewise framework. I've chosen the RP High strategy for comparison, for which my expectation is a return near or slightly above the S&P 500 over the long-run but with far greater stability.

S&P 500 vs. RP High Annual Return Distribution, 1972 to Present

Simulated data based on end-of-day index prices and includes all dividends. See full disclosures at end of article.

While the real-world data is a little messier, it still about lines up with the expectation. The RP High framework actually has a lower median return but a higher average return than the S&P 500. In other words, you will tend to underperform the S&P 500 in any given year, but you will still outperform it over time. This is primarily driven because you avoid the major 'left tail' negative shocks, like 2008, that only come around once in a while but make an enormous difference to your net returns.

This year, clients in RP High have a return of 12.8%, which is maybe a little better than average but still pretty typical. Same goes for the S&P 500, which returned 17.25%. When you put this in context of the theory, this is exactly what you'd expect! It would be silly to judge this underperformance against the S&P as a bad thing. It would also be silly to call this a 'bull market' for Risk Parity when really it is just a normal market.

On a related note, the messiness of the above chart highlights why an annual timeframe isn't all that useful; it generally takes a longer time to see the true benefit of stability.

Timeframes: Understanding Days, Months, Years, and Decades

Especially during extended equity bull markets, I naturally run into lots of skepticism about whether risk-management is really that useful when you could do so well in any old index fund. The key question this raises is, how long does it usually take to see definitive proof?

You can probably guess that it takes about as long as the typical equity bull market, since most of the benefit accrues when stocks are doing poorly. With the average bull market lasting about ten years, let's extend the timeframe to that length and take a look at the same return distributions as earlier. According to the theory, the risk-managed framework should almost always outperform stocks given this amount of time.

S&P 500 vs. RP High 10yr Return Distribution, 1972 to Present

Simulated data based on end-of-day index prices and includes all dividends. See full disclosures at end of article.

These results are pretty amazing: Risk Parity avoids any negative returns and consistently outperforms equities, even during the strongest bull markets in history. That said, waiting a full decade can be a bit of tall order for most clients; luckily, you can see these same benefits in as little as three years if you have the right perspective.

S&P 500 vs. RP High 3yr Return Distribution, 1972 to Present

Simulated data based on end-of-day index prices and includes all dividends. See full disclosures at end of article.

This shows that Risk Parity usually generates equity-like returns over any three year period, but with far less risk of incurring a net loss. However, this just isn't a long enough time to expect that you'll definitely outperform stocks, nor should that be particularly important. If it happens to be a stretch where stocks do poorly, the benefits will be obvious. If not, you'll probably have returns between 15% and 100%, and you didn't have to worry whether a crash was just ahead.

Now we'll look at one final comparison that is purposefully messy: one month returns. As you might expect, such a short timeframe doesn't really tell you much of anything.

S&P 500 vs. RP High One Month Return Distribution, 1972 to Present

One month returns are almost pure noise. You may frequently lose a few percent, you may often underperform equities, and you may have many consecutive months that are flat or down. Despite this, if you simply wait three years, you'll probably have some nice gains.

This is why I'm never very focused on recent history, nor am I surprised about all of the ups and downs along the way. Rather, I care most about market shocks, like the bond pullback of 2016, which let you see the hedges really working. In calm waters, I only expect moderate upward trending returns over the course of a few years, and 2017 has fit that to a tee.

Returns: Where They Come From, What They Mean

So far, this analysis has focused on how to evaluate the benefits of a more stable return over time, but it still begs the question of where that return comes from and why it should be consistently positive at all. It is also fair to ask whether very high returns are often followed by very low ones, and vice versa, since this tends to be the case with individual assets like stocks or commodities.

The beautiful thing about public markets is that at any given point in time, every individual participant is expecting to make money no matter how much they have made already. To enable this, investors apply a discount to every asset they buy that bakes in an expected return. Generally, that discount gets applied to expected cash flows, e.g., actual profits at a company or coupon payments from a bond.

It's useful to illustrate this with a simple hypothetical. Say Company X is valued at $100 per share and expects to make $10m per year now and forever into the future. An investor would simply discount that $10m to come up with the value today and divide that by the number of shares to get $100.

Now say a year passes and nothing at all has changed with the company. They made $10m, and they expect to continue to make that now and forever into the future. The same investor runs the same analysis and values the company at $100 per share. But something very important has changed. A year has passed, and anyone that owns a share of the company just got a piece of the $10m in profits.

This is a very important distinction because there is often confusion that the only way to make money in the markets is if prices continuously go up. But this is not true. You can make perfectly reasonable returns over time even if prices stay exactly the same.

This powerful concept explains how you might achieve positive returns every year without any kind of irrationality or price bubble. In financial parlance, these returns are called "risk premia", and Hedgewise simply builds products to collect these risk premia as efficiently as possible.

The rub is that sometimes investors get overexcited about prospects that won't ever actually make any profit, like during the dot-com bubble or, if I were guessing, the current cryptocurrency craze. In these cases, asset prices can skyrocket without any real money being made, and fall just as easily.

A hypothetical illustration of expected asset returns would look something like this:

Theoretical Asset Return Patterns

The blue line represents a theoretical live market, in which asset prices often swing up and down with investor speculation. The orange line is the underlying risk premia (i.e., actual profits being made or paid back to investors) that accumulates along the way, and basically represents fair value. While live market prices constantly fluctuate above or below this fair value, you still expect appreciation over time.

In other words, consistent positive returns over time are perfectly normal, and negative returns are unlikely to persist for very long. If you had perfect insight, you could also time every individual top and bottom, but it is hard to justify all of that effort when you can gain so much by just waiting.

If this theory is accurate, you'd expect big losses to reverse far more consistently than big gains, especially in a framework like Risk Parity. Let's see whether this has been true. The following is a scatterplot where the horizontal axis is the trailing one year return, and the vertical axis is the following year's return. The bottom left quadrant (emphasized) represents the instances when you had two consecutive years of loss.

Last Year's Return (X Axis) vs. This Year's Return (Y Axis), Risk Parity High

Simulated data based on end-of-day index prices and includes all dividends. See full disclosures at end of article.

Notice that there have been only two periods of consecutive annual losses, out of over five hundred data points. The large majority of the time you have had two consecutive years of gain (upper right quadrant). There's also no evidence that really large gains are consistently followed by losses.

Basically, it is really hard to lose money over any reasonably long stretch of time because you get a constant positive lift from risk premia. Losses tend to disappear pretty quickly, and gains tend to persist. We've recently seen a great example of this when losses in 2015 very quickly reversed in 2016. This year, RP High is up about 13%, which is quite normal and doesn't suggest that next year will be a bad one.

Wrapping Up: An Approach with Better Answers

Once this theory starts to click, it really provides a much more satisfying set of answers than traditional portfolios or managers can. Are equities overvalued? It has really never mattered much. Are we underperforming the S&P? Quite frequently, but that's how I know it is hedging well. Are my managers smart enough? No managers required, we're just systematically gathering returns in a smart way. Did we lose money this year? Maybe, but if we did, there is an exceedingly high chance that we're about to make it back.

In a world of stock-pickers, real estate bubbles, and irrational exuberance, it is completely natural to approach investing reactively and to constantly worry about what's next. Fortunately, the financial theory behind Hedgewise allows you to shift to a much calmer mindset, where short-term swings and big asset crashes are much less of a concern. 2017 has been one more data point that the theory is working just like it should. The fact that such a good year has been no surprise provides all the more reason for optimism heading into next year.

Happy Holidays, and hopefully Hedgewise has made it a little easier to enjoy without worrying about the markets!

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Q3 Update: Hedgewise Outperforming Every Asset Class in 2017
Posted in Market Commentary on 2017-08-28

Summary

  • Year-to-date, Hedgewise continues to outperform equities as well as most major competitive benchmarks.
  • Both the Risk Parity and Momentum frameworks have exceeded the 10% return of the S&P 500 (at comparable risk levels) while maintaining the benefits of risk management.
  • Many investors have missed this rally or transitioned to cash for fear of potential negative shocks, but Hedgewise client portfolios remain uniquely prepared for changing market conditions.
  • Various strategies have done well in this remarkably calm environment, but few are well-prepared if volatility returns. I've examined some of the largest negative events of the last 50 years to explore how Hedgewise frameworks build in protection.

Bull or Bear Market? Doesn't Matter Much

Since the election last November, I read about one article a day discussing equity outflows, stock bubbles, bond bubbles, and every kind of warning in between. Of course, many raise valid concerns and highlight lots of indicators that suggest a downturn is right around the corner. Despite that, stocks have been on an incredible run, gaining over 10% this year and nearly 20% since November. Unfortunately, an estimated 45% of the country has missed out on it, perhaps in no small part due to the warnings around every corner.

Events like 2008 tend to leave an unforgettable mark on investors, and who can blame them? Yet the possibility of a 50% loss - and the corollary temptation to try and wait for the 'right time' to get in - results in an enormous hidden drag on most portfolios. While most investors naturally use the S&P 500 as a benchmark, that is deceptive if they would never be comfortable using a 100% stock portfolio. This is why I consider risk management techniques to be far more than some absolute return; the extra protection can fundamentally change the ability for many to invest at all.

In my last article, I discussed a few of the underlying theories that drive the construction of Hedgewise portfolios. A significant recurring theme in that research is the ability to use a combination of leverage and risk management to add protection to a portfolio without sacrificing returns. This is a departure from traditional hedging techniques, like covered calls, protective puts, or moving some of your portfolio to cash, which all have a substantial expected cost. 2017 has been a nearly picture-perfect example of this concept in action, as both the Hedgewise Risk Parity and Momentum strategies have outperformed the S&P 500 while still retaining significant downside protection.

However, what most excites me is not the absolute return itself, but rather the success of the risk management techniques underlying it and how those factors continue to provide protection that most traditional portfolios do not. For example, Hedgewise frameworks successfully avoided much of the energy correction in the first half of this year, added copper exposure to better hedge against inflation, and remained patiently overweight in equities despite the incessant political turmoil. These systematically-driven adjustments have driven better performance than major competitive funds this year, but I expect their value to become even clearer when stock volatility inevitably returns.

Year-to-Date Performance Review

Here is how Hedgewise products have performed against every major asset class. This is the composite performance across all live clients in Risk Parity or Momentum at the "Max" risk level, which uses a similar target volatility to the S&P 500. All fees and costs have been included.

2017 YTD Performance of Hedgewise Products vs. Major Asset Classes

Benchmarks based on end-of-day prices of publicly available index data.

This performance is particularly notable for Risk Parity, which has beaten stocks despite a significant allocation to bonds and commodities. Momentum has remained heavily weighted to equities throughout the year, ignoring the political noise that has had little long-term impact on the trend.

Hedgewise products have also outperformed most major competitive benchmarks, such as the iShares Core Allocation Funds (AOK, AOM, AOA), the PowerShares and Cambria Momentum Funds (PDP, GMOM), and the AQR and Invesco Risk Parity Mutual Funds (AQRNX, ABRYX).

Hedgewise YTD Performance vs. Comparable Traditional Benchmarks


ProductYTDBenchmark (Ticker)
RP Med.7.5%5.5% (AOK)
RP High9.4%6.45% (AOM)
RP Max12.7%10.65% (AOA)
MM Max15.7%14.26% (PDP)
Hedgewise performance based on a composite of all live client portfolios in each risk level and includes all costs and fees. Benchmarks based on end-of-day prices and include all dividends re-invested.

Hedgewise YTD Performance vs. Risk Parity Mutual Funds

Hedgewise performance based on a composite of all live client portfolios in each risk level and includes all costs and fees. Benchmarks based on end-of-day prices and include all dividends re-invested.

Hedgewise YTD Performance vs. Momentum ETFs

Hedgewise performance based on a composite of all live client portfolios at the Max risk level and includes all costs and fees. Benchmarks based on end-of-day prices and include all dividends re-invested.

Across every dimension, Hedgewise products have consistently outperformed. While this is very exciting, many of the competitive funds - especially in the Momentum space - are not built with the same level of downside protection. The value of this protection will only become evident during a sustained, multi-month equity drawdown event. Since that hasn't happened recently, we can model history to get a better sense of what this might mean.

Preparing for Shocks: What to Expect in the Next Correction?

Quantitative frameworks like Risk Parity and Momentum can be difficult to evaluate because fund managers often run them quite differently. Above, you can see that despite a high level of correlation, the Invesco Risk Parity fund has returned about 4% this year compared to more than double that for Hedgewise. While that is relatively easy to evaluate, differences are often more muted in normal market conditions. For example, almost every variation of Momentum has had a relatively good year.

The problem with many quantitative frameworks is that they work only within an asset class rather than across multiple asset classes. In the case of Momentum, many strategies invest in the top trending equities at any point in time, but would never invest in a separate asset class like bonds. This can work very well so long as equities as a whole are trending up - a rising tide lifts all boats. In a severe market correction, though, such techniques often provide little protection.

To get a sense of this, I examined the performance of the PowerShares Momentum ETF (PDP), one of the oldest public frameworks available, during the last recession. I also compared this to the simulated model results of the Hedgewise Momentum strategy set at a similar level of risk.

PowerShares Momentum ETF (PDP) vs. Hedgewise Momentum Model, 2007 to 2009

See full disclosures on Hedgewise model simulations at the bottom of this article. PDP performance based on end-of-day prices and includes all dividends re-invested.

The simple explanation for this enormous difference in performance is that the Hedgewise model moved entirely into bonds prior to the recession, while PDP is limited to always being 100% equities by rule. To be clear, there is absolutely no guarantee that the Hedgewise framework will always catch such events. Yet at least it has a chance to get out of the way, while frameworks like PDP are limited by definition.

Again, there remain a wide range of events in which Hedgewise could not avoid losses, and 2008 performance is more of an exception than the rule. But the strategy frameworks are entirely built with these kinds of events in mind. To get a better sense of the range of likely outcomes, I examined the worst equity pullbacks since the 1970s to see how Risk Parity and Momentum held up (both set to the Max risk level).

Historical Performance of Hedgewise Momentum and Risk Parity Models


PeriodStocksMom.RP
Aug. 08 - Nov. 08-34.5%24.1%1.2%
Jun. 74 - Nov. 74-27.7%1.3%-9.1%
Aug. 87 - Nov. 87-26.1%-22.2%-6.5%
Mar. 02 - Jul. 02-21.2%3.2%7.7%
Jul. 11 - Sep. 11-17.5%-3.1%10.2%
Jul. 01 - Sep. 01-15.7%9%8.6%
Jun. 98 - Sep. 98-13.8%-10.3%14.1%
Simulated models rely on end-of-day index prices and use identical risk management algorithms to those in place today. Asset classes limited to equities, bonds, gold, and oil. All dividends assumed re-invested. See full model disclosures at the end of the article.

Across the board, both Hedgewise models consistently outperformed equities over the course of these "worst case" events. There will absolutely be some years, like 1987 or 1998, in which losses are inevitable. If you can successfully hedge even a few of these events, though, the impact on your long-run return will be enormous. Yet this will only be possible if you are using a quantitative framework that is focused on this type of risk.

The important hidden advantage of this approach is how it can shift your mentality as an investor outside of the raw returns. Once you know that a sophisticated quantitative approach is doing everything it can to manage timing risk for you, you can pay far less heed to the hundreds of warnings in the news every day. You won't avoid every loss, but you gain the confidence to stay patient regardless as the probabilities are engineered to be heavily tilted in your favor.

Looking Forward: Late-Cycle Environment

It would be unrealistic to expect the low volatility and stable positive returns of the past year to continue unabated. There's a good chance we will remain in a 'late-cycle' environment for the foreseeable future, which means that the economy will grow fast enough for the Fed to be concerned about inflation, but investors will stay nervous that growth is slowing down or that some geopolitical shock will throw everything into disarray. Against this backdrop, I'd expect quite a bit of chop across all asset classes, but it's unlikely that much of it will be meaningful. Both Hedgewise frameworks remain excellent choices for such an environment, regardless of short-term returns.

While I don't see any major systemic financial risks currently unfolding, I'm far less nervous about that possibility than most since Hedgewise frameworks have been so carefully constructed to account for it. In a sense, this bull market has actually been a challenging stretch because investors may fail to see the value of risk management when stocks continue to do so well. Fortunately, Hedgewise techniques are built to weather all kinds of conditions, and have consistently outperformed equities regardless. Whenever the next bear market does unfold, it will be exciting to observe what I expect to be an even bigger difference between Hedgewise and most traditional benchmarks.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

Understanding the Theory Behind Better Returns
Posted in Investment Strategy on 2017-06-21

Clients in the Momentum Max product have an average of a 15% YTD return compared to a 9% YTD return in the S&P 500, including all dividends re-invested and all costs and fees. Clients in the Risk Parity Max product have a 25% lower volatility of daily returns compared to the S&P 500 since 2016. Past performance is no guarantee of future returns. Different Hedgewise products are more suitable for different client goals, and will have different risk and return profiles. See full disclosures at end of article.

The Foundation of Outperformance

Hedgewise was founded on the idea that core financial theory can be used to improve returns and reduce risk. By focusing on 'first principles' of markets - why they function the way they do, what drives prices, and how they relate to broader economic trends - Hedgewise develops theories that are similar in nature to those found in the physical world, like the laws of gravity. Any truly superior and lasting investment strategy must have such a basis to be relied upon over many decades.

While it may initially sound outlandish to compare financial theory to the laws of nature, there are a number of well-known ideas that already rise to this level. Diversification is probably the most familiar, which asserts that holding a basket of assets will always result in better returns with less risk than holding just a few. This largely explains why more than 90% of stock-picking managers have failed to beat index benchmarks over the last 15 years.

On the other hand, there is also a misperception that passive index funds are the best and final application of financial theory. For example, if you are relatively young, should you invest entirely in equities? Should you account for radical events like the real estate crash? Should you use leverage in your portfolio? These questions can dramatically alter the composition of your portfolio, but passive funds provide few compelling answers.

The reality is that passive index funds are better building blocks of a portfolio than individual stocks, yet they only represent the tip of the iceberg in terms of understanding and applying financial theory. As time goes on, I believe 'active' management will remain alive and well, but will be represented only by funds which have developed a deeper and more accurate understanding of how markets operate, rather than a handful of individual stocks. These new kinds of portfolios will naturally outperform simple passive strategies in the same way that those simple strategies have outperformed stock-picking: because the theory represents something true and unavoidable in the marketplace.

Every Hedgewise product is built on this same philosophical foundation, and there have been a number of recent market developments that lend further proof that the theories in use are quite powerful, and already producing superior outcomes for Hedgewise clients.

Theory One: A Foundation of Risk Premia

A 'risk premium' is the amount that an investor discounts the expected returns from any investment to compensate for the possibility of loss, and to account for other competitive potential investments. For example, if you might realistically lose half your money, you'd expect a higher potential return than if you might only lose 5% of your money.

We can call the amount an investor is willing to pay for an investment today it's 'Present Value', and represent that calculation with the following formula:

Where 'rf' is the risk-free rate, and 'rp' is the risk premium attached to that investment. The higher the risk, the less you are willing to pay for an investment today. The more skilled investors are at understanding and predicting the future, the closer you'd expect their realized return to match the risk-free rate plus the assigned risk premium.

If this theory holds, you'd also expect to see higher realized returns for stocks than government bonds, since you are basically guaranteed a return on bonds if you are willing to wait until maturity. You'd also expect a higher return on bonds than on commodities, since commodities have many various uses outside of being a pure investment (e.g., you can use sugar to make food products for a profit).

If this theory is true conceptually, you'd expect return curves to look something like the following:

Theoretical Realized Return Bell Curve, by Asset Class

This conceptual basis is important because it provides a framework for answering some interesting questions, mainly:

  • How skilled are investors in different asset classes at predicting the future? The more skilled they are, the more that returns should converge with the assigned risk premium.
  • Does the theory hold up over certain time horizons but not others? For example, if the theory generally holds up for annual returns but not for monthly returns, then it might be reasonable to attribute monthly returns to random noise and not worry too much about explaining them.

With that in mind, let's take a look at the actual bell curves of asset class returns over a number of different time frames. I'm using the returns of the S&P 500, 10yr Treasury Bonds, and gold as a proxy for commodities. These returns represent the trailing gain or loss for the given time frame, in other words, for the 1yr horizon, you are seeing the trailing 1yr returns for that asset class for every month in history.

One Month Trailing Return Distribution by Asset Class

One Year Trailing Return Distribution by Asset Class

Three Year Trailing Return Distribution by Asset Class

In the final graph using three year trailing returns, the curves are certainly starting to resemble what we expected in theory. This suggests that risk premia are a real force, and that investors are always expecting a positive return from the markets. Because the curves tighten as you look over longer timeframes, it's likely that investors are modeling risk well enough to smooth out most short-term volatility, especially over one month or one year. However, every asset class (especially stocks and commodities) still has a nagging 'left tail' of significant losses even over three years.

Since we just established that investors are formulaically expecting a return, and attempting to account for future risks, the only reasonable explanation for long-term losses are substantial, low probability, or entirely unforeseen negative events.

This leads to a few key parts of how Hedgewise manages its funds:

  • I primarily care about gathering as many risk premia as possible, which means I never fight against the markets via things like covered calls or naked puts (although I may short negative risk premia, like in the oil markets).
  • I care very little about the normal deviation of prices or upcoming events that are well-known, the impact of which are pretty efficiently smoothed out over time. Instead, almost all of my research is based on managing potential hidden or poorly forecasted shocks that will radically shift markets.

Tying this back to the theory, this is how I think about the earlier bell curve of one month trailing returns:

This also helps explain why I do not consider short-term losses, especially week-to-week or month-to-month, to be much of a concern. In other words, I am never trying to predict near-term price movements. Rather, I am managing the risk that a major, negative event might occur. Unless such an event happens, your best move is generally just to do nothing and trust that the odds are heavily in your favor.

Interestingly, this sheds light on why so many active investors get into trouble. There is an enormous amount of noise in short-term returns, and trying to predict it is both really hard and mostly unnecessary. It also dispels the notion that economic indicators like price-to-earnings ratios or the length of the current bull market matter. Investors are pretty reliable in applying risk premia to all currently known information, and they are still building in a positive return expectation. Given that, it's usually a bad idea to avoid the market because it feels 'overvalued'.

Since launching last November, the Hedgewise Momentum framework has provided a nice example of this theory in action. The theory suggests that most of the time, especially over periods of five years or more, equities will yield a positive return. Then it follows that most of the time, it is safe to be 100% in equities - in fact, it might even sometimes make sense to use leverage and go more than 100% into equities, especially if you ignore normal monthly noise and don't overreact to market events that aren't meaningful, like the types described earlier. The Momentum product is structured to primarily revolve around these ideas and is usually overweight equity markets to varying degrees.

Here's how the Momentum product has performed in live Hedgewise client portfolios since launch. This data is a composite of all live client portfolios using the "Max" risk level, and includes all costs, fees, and dividends as of end of day on June 14th, 2017.

MonthMomentumS&P 500
November 20167.02%4.81%
December 20162.87%2.00%
January 20172.35%1.97%
February 20176.56%3.90%
March 2017-0.46%0.14%
April 20172.18%1.08%
May 20172.68%1.33%
June 20171.98%1.25%
Total27.87%17.64%

The outperformance of the product so far ties directly back to the concepts being discussed: equity markets are behaving in a normal range, and the types of market events that have been unfolding over this period, like the US elections, are relatively normal and foreseeable. While the return looks great, it's simple market theory at work.

A natural question is whether this performance would quickly reverse if stocks start to do badly. However, unlike a purely passive index, Hedgewise layers on additional kinds of risk management to maximize the chance that clients will hold on to their gains.

Theory Two: Behave Conservatively in High Risk Environments

The other major piece of the puzzle is the ability to catch major negative market shocks. However, theory suggests that you don't actually need to do be able to predict such events with great accuracy; even if you are only right 20-30% of the time, you'd still expect such a bet to be profitable.

There are two main reasons for this. First, there is the simple law of percentages: If you lose 50%, you then need to then gain 100% to get back to breakeven. Every time you successfully avoid one negative return, you can afford to miss out on a positive return of a greater relative size.

Second, there is the assumption that markets will be working normally far more often than not. Essentially, you are not usually expecting to have an equal chance of making or losing a large amount. Rather, you are expecting a very small chance of losing a large amount and a very large chance of making a small amount. If this is true, you can afford to be wrong about negative shocks far more often then you are right (since you usually don't miss out on very much when you are wrong, but you save a ton when you are right).

To understand this, it is useful to look at another view of the data. The following is a distribution of all realized one month returns for the S&P 500.

All One Month Trailing Returns of the S&P 500

The goal is to develop an ability to manage risk such that you can avoid a few of the extremely negative returns above. As laid out in the theory, you don't have to have a high probability of success for this to be worthwhile: avoiding one large negative return will compensate for missing many smaller positive returns. There is also no expectation that we can avoid every loss - we only expect that our overall returns will be higher than if we had done nothing to manage risk at all.

The following compares the original chart to a new distribution that removes all historical points deemed 'high risk' using the Hedgewise risk filter.

Comparison of All S&P 500 Monthly Returns to Risk Filtered Monthly Returns

Notice that the overall distribution of the risk filtered returns has shifted slightly upward, resulting in an average monthly return that is 0.56% higher than the unfiltered data. Even though not all negative months were caught, the impact of removing a few was more than enough to significantly improve the result.

Of course, the results above depend entirely on the quality of the Hedgewise risk filter, which was modeled with the benefit of hindsight. Luckily, we now have a few live data points to examine how it has been performing in real portfolios.

The current iteration of the Hedgewise risk filter was rolled out to live client portfolios in August 2016, and there have been two asset classes which have had months identified as 'high risk' since then: bonds and energy. Let's take a look at how the risk filter performed over this time period.

Comparison of 10yr Bond Monthly Returns to Risk Filtered Monthly Returns Since August 2016

Note that the "X" represents the mean of the data series.

In the bond markets, the average monthly return shifted up by 0.55% using the live risk filter.

Comparison of WTI Oil Monthly Returns to Risk Filtered Monthly Returns Since August 2016

Note that the "X" represents the mean of the data series.

In the energy markets, the average monthly return shifted up by 2.5% using the live risk filter.

These results are incredibly encouraging but consistent with what was expected. To review, we are behaving conservatively in high risk environments even though we will be wrong most of the time. Because of the nature of markets, the few times that we are right will still lead to improved returns in the portfolio.

Creating risk filters for individual asset classes is only one pillar of risk management at Hedgewise, though. You can layer on additional techniques, like hedging, to improve even further.

Theory Three: Commodities as Free Insurance

I've already written a number of previous articles on how hedging works, so I want to focus here specifically on the role of commodities, specifically gold. As you may have noticed earlier, gold has a realized return close to zero, so it makes sense to wonder why it belongs in any portfolio. You may be even more surprised to learn that I usually expect gold to be a drag on the portfolio, but it is still absolutely worth holding.

To understand this, you need to reframe the different functions that an asset can have. The most intuitive function is to drive positive returns, and I discussed how risk premia drive such returns in assets like stocks and bonds in the first section. However, an asset can also serve a role as insurance, and if it does so effectively, it no longer requires any expectation of a return.

Consider a case where you could actually buy insurance on a portfolio invested 100% in equities. You'd expect to pay a premium to an insurer, who would then agree to reimburse you if stocks fell below a certain value. Most of the time, you'd be losing money by having the insurance, but it gives you protection against extreme events.

In theory, gold provides almost exactly the same kind of protection as this hypothetical insurance, but is basically available for free. As a physical metal, gold will generally retain value over time and keep up with inflation, as it is often used as a substitute for currency. This also makes it useful as a safe haven for investors who fear radical events like a run on banks or a government default, since their bank accounts or bond holdings would no longer be secure. As such, gold prices do particularly well in times of runaway inflation or when investors feel very afraid, like during a major global crisis.

Still, gold is not useful in a portfolio if you have to remove something with a higher expected return to make room for it. For example, a portfolio of 100% stocks would have a higher return over time than a portfolio of 85% stocks and 15% gold, since the gold portion would probably yield very little. However, you can transform gold into a form of insurance with no drag on returns if you introduce leverage to the portfolio.

For example, consider a portfolio of just 100% stocks versus a portfolio of 105% stocks and 15% gold. The latter portfolio is leveraged by 20%, meaning you took out a form of loan. This loan will have a small cost, typically near the risk-free rate, but in exchange you now have protection from global crises and runaway inflation. In theory, the cost of adding gold to the portfolio will be less than the amount you gain by leveraging extra exposure in other asset classes.

This theory is easy to test by modeling the exact portfolios mentioned. These numbers use end-of-day index prices, include the cost of leveraged measured as the rate on the 1yr Treasury Bond, and include all dividends and coupons re-invested. Gold first became tradable in 1970.

Comparison of 100% Stocks to 105% Stocks / 15% Gold, 1970 to Current

This result is both unsurprising but incredible at once: you increased your annual return by almost 1% with very little increase in risk or maximum losses! Yet this makes perfect sense: you increased your expected return by owning more stocks, but you mitigated the risk of that extra exposure by adding the insurance of gold. Leverage allows you to manipulate the portfolio to effectively gain insurance and boost returns at the same time.

However, just like insurance, gold will rarely have a positive return except in circumstances of elevated fear or inflation. Outside of these events, the expectation is that gold will be flat or negative. This in no way changes the fact that it is having a positive overall effect on your portfolio.

As a result, it is unfair to judge gold on its raw performance over a few months or even a few years. A better way to evaluate it is whether it is properly hedging the kinds of events you expect. While we haven't had any kind of major global crisis or hyperinflation since Hedgewise opened its doors, gold has still demonstrated its safety whenever the possibility has arisen. Here's how gold performed during the three worst months for the S&P 500 since 2015:

DateStocksGold
August 2015-8.61%4.62%
December 2015-4.11%0.60%
January 2016-3.47%5.02%

Gold nicely hedged the losses of August 2015 and January 2016, which were driven by worries of systemic economic problems in China. It didn't do much in December 2015, as that pullback was centered around actions at the Fed, but it clearly remains a safe haven whenever a global crisis gets more likely. There was another nice example of this on the day of the Brexit in June 2016, as gold rallied 5% overnight.

While none of these events materialized into an economic downturn, gold provides a persistent hedge that allows us to improve portfolio construction in other ways. When the next downturn finally does arrive, gold will even more dramatically redeem its value.

Wrapping Up: Financial Theory in Practice

The past two years have provided an excellent, real life demonstration of the financial concepts underlying every Hedgewise product. Unlike active managers of the past, Hedgewise rests on a foundation of theory that, if true, can fundamentally improve returns and reduce risk in the same way that simple diversification does. While it is still relatively early days, the evidence so far has been amazingly close to what you'd expect to see, and this has already been driving outperformance for clients.

By understanding and gathering risk premia, Hedgewise products have a basis of positive returns built-in. Then, multiple risk management techniques are layered on top of this to make the portfolio less likely to be impacted by sudden negative shocks. Portfolios gain a kind of 'free insurance' by more effectively managing and hedging high risk environments, and leverage is used to make this possible without weighing down returns.

In the short-term, this can sometimes be confusing to watch. Assets like gold frequently have a negative return, and sometimes there are large losses which cannot be avoided. Risk algorithms are imperfect, and frequently appear to move in or out of an asset at just the wrong time. Yet when you step back and examine the underlying theory, this is all within the range of expectations. Even better, when you look at the evidence available since Hedgewise opened, it's obvious that the net result has been quite positive. I'm very confident that the more time goes on, the clearer the benefits will become.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

April 2017: A Great Start to the Year
Posted in Market Commentary on 2017-04-10

Summary

  • Hedgewise products have significantly outperformed benchmarks in 2017, with YTD returns of over 8% for clients in higher risk levels.
  • The tumultuous political environment has pushed many investors to be overly cautious due to a misperception of how much influence the President has on the economy.
  • Meanwhile, Hedgewise risk algorithms have navigated the environment quite smoothly, including a significant reduction of oil exposure prior to the recent pullback.
  • While Hedgewise performance has been strong, there were moderate losses in the first two weeks of March. However, this was quite natural and no cause for concern. In fact, it presents a great case study for why short-term losses rarely matter within the Hedgewise framework.

Politics Dominate the News, but Not the Economy

Recently, the headlines have been overwhelmed by news coming from the White House. There has already been post-election euphoria, a failed Repeal and Replace effort, an escalation of conflicts in the Middle East, and an endless stream of Russian intrigue. Given that, many pundits have naturally attributed the stock market rally since November to optimism over President Trump, and now worry that recent turmoil will quickly reverse the gains.

While this makes for a good story, it doesn't hold up in the real world. Outside of major economic crises requiring government intervention, like the bailouts in 2009, policy doesn't have all that much to do with Wall Street. Investors are largely rational, and value every individual company based on its bottom line and future growth prospects. Given that, it's hard to imagine that every company was suddenly worth 10% more because Trump might reduce regulation, cut taxes, and invest in infrastructure. Even if all of this happened - and everyone knows that is a big if - it wouldn't come close to justifying such an increase in valuation.

The reality is that the US economy had significant tailwinds up until the last month or so. Unemployment continued to drop, inflation finally started to pick up, and the Fed became confident enough to significantly accelerate interest rate increases. This explains most of the stock rally, as well as the dramatic correction in bonds last October and November. The macroeconomic data coming in for the first quarter has cooled off a bit, though, and stocks along with it.

The point is that it makes far more sense to follow the data than to follow the news. Thus far, the numbers say that investors aren't particularly worried about Trump destroying the economy. He would need to bungle something major (like starting a trade war) to have any real impact, but nothing that has happened so far has caused much worry.

Against this backdrop, it has actually been a relatively stable few months in terms of risk. Since the Hedgewise framework is entirely quantitative, there was no chance of overreaction to the news, leading to significant gains for most clients. To better frame relative performance, I've compared Hedgewise products to more "traditional" portfolio mixes, represented by the iShares Conservative ETF (AOK), the iShares Moderate ETF (AOM), and the iShares Aggressive ETF (AOA). I've also shown a separate graph of the Hedgewise Risk Parity+ strategy compared to the largest competitive mutual funds.

Hedgewise YTD Performance vs. Traditional Portfolio Benchmarks

ProductYTDBenchmark (Ticker)
RP+ Medium4.22%2.51% (AOK)
RP+ High5.34%2.9% (AOM)
RP+ Max7.51%5.19% (AOA)
Momentum8.55%5.96% (SPY)
L/S Oil-6.86%N/A

Hedgewise Risk Parity+ vs. Largest Competitive Mutual Funds

All Hedgewise YTD returns based on a compilation of live client performance in each product, including all costs and fees. Note that Momentum is set to the "Max" risk level, which best approximates a similar risk level to the S&P 500. Clients in lower risk levels will have lower performance. Benchmarks based on end-of-day prices and include all dividends and fees.

These performance numbers are exactly what you'd want to see: for a given level of risk, clients have generally achieved higher returns. While Long-Short Oil has incurred losses, they are quite typical of the swings inherent to that strategy, which tends to be both streaky and extremely volatile (Note that I generally will not provide more detail on alpha products due to their proprietary nature).

Looking forward, it's likely that one of stocks, bonds, or gold will reverse course, as it doesn't really make sense for them all to have appreciated together. While this may result in a short-term dip, as we saw in early March, this is a natural part of the process and has no bearing on long-term returns. As risk unfolds, Hedgewise algorithms shift to ensure your outlook remains bright regardless.

How Risk Algorithms Are Driving Performance

In the first quarter of this year, risk signals were relatively low in every asset class besides oil, which had its exposure reduced beginning in January. These signals are not meant to be predictive of positive or negative returns; rather, they reflect some possibility of a large correction. Oil provided an excellent example of such a risk unfolding over many months. Even though net losses have not been significant, the system was still accurate in identifying the possibility of severe downside.

Oil Exposure By Month In Hedgewise Risk Parity+ Model

Data based on Hedgewise models that are broadly consistent with those currently being used in client portfolios.

YTD Price Change of WTI Oil

Source: EIA

This is a great example of the kind of risk that is the primary focus at Hedgewise. As intended, the system was overly conservative, and reduced exposure to oil all the way back in January. Oil went on to rally slightly from mid-to-late February, but this had little impact on the overall risk assessment since short-term movements are not the focus. By March, the risk had been fully realized, with oil prices dropping by over 10% in a matter of days. Despite a subsequent recovery, the risk assessment was spot on. Even if oil manages to fully recover from its losses, it was still absolutely worthwhile to trim exposure given the general environment.

Conversely, all other major asset classes have been relatively stable (in other words, not demonstrating a risk of a major downside event). This doesn't mean all these assets were expected to appreciate; in normal conditions, you'd expect some to do well and others to do poorly, and thus drive a balanced positive return. However, markets frequently behave oddly over short periods of time, as can be seen by the YTD returns below.

YTD Returns by Asset Class

AssetYTD
S&P 5005.96%
Treasury Bonds2.0%
TIPS Bonds2.11%
Gold8.98%
Oil-2.7%
Based on end-of-day index prices. Includes all dividends and coupons.

While these returns suggest some disagreement across markets, they still led to a great few months of performance for Hedgewise clients. That said, it's easy to see that this is not sustainable. If real economic growth is high, TIPS should be doing terribly unless there is a great deal of inflation. However, in that case, Treasury Bonds should be tanking. This generally indicates that the players in the different markets have different views, at least one of which is not correct.

This means that one of these asset classes is probably overvalued, but no one knows which one yet. This is a very different category of risk than the one discussed in the oil markets: this involves short-term price distortion despite a generally solid base. To address it, you'd need to accurately predict weekly directional price movements - which is incredibly difficult and resource-intensive.

Rather than seek such precision, Hedgewise simply waits for these forces to play out and bets on an overall positive return regardless. A good example of this process happened in early March which is instructive to examine in greater detail.

Examining the March Dip

Here's a closer look at the pullback in the Risk Parity strategy in March.

All Hedgewise YTD returns based on a compilation of live client performance in each product, including all costs and fees. Benchmarks based on end-of-day prices and include all dividends and fees.

There's three key reasons this particular pattern should raise no concern. First, notice the symmetry in the graph: almost immediately prior to the pullback, there was a nearly equivalent rally. Such fast gains, especially in a balanced portfolio like Risk Parity, often suggest that something is out of balance and will need to correct. Second, there's absolutely no need to try and avoid that correction because it won't matter in the big picture. Finally, attempts to manipulate performance in this short of a time period are very dangerous and can easily backfire.

To better prove this, I took a look at the limited Risk Parity model that runs back to 1972, and isolated all of the years in which there was a single month with losses of 7% or more. I compared that alongside the annual return for that same year to see how much of an effect those large short-term losses had overall.

Impact of Large Short-Term Losses on Annual Returns, Risk Parity Model

YearWorst MthAnn. Return
1973-7.0%-7.49%
1976-7.1%35.44%
1978-12.4%-3.06%
1979-7.8%34.94%
1980-8.1%44.36%
1981-10.7%-11.59%
1982-8.8%69.10%
1984-7.3%1.56%
2000-7.6%9.77%
2003-8.2%28.41%
2004-8.0%8.95%
2011-7.8%31.18%
2012-7.1%8.05%
2015-8.1%-11.89%
Avg.-8.28%16.98%
Based on a hypothetical model using the same risk algorithms in place today, but limited to the S&P 500, Treasury bonds, and gold. Set to the "Max" risk level. Uses end-of-day index prices and accounts for all dividends and coupons. This is not based on a live portfolio.

In years when you lost 8% in a single month, you went on to gain an average of 17% regardless! While this may seem counterintuitive, it all comes back to balance and effective risk management. Since all assets tend to appreciate over time, you almost always win simply by waiting for markets to work things through.

Looking Ahead

Summing all this up, the outlook is generally positive but with expected chop along the way. Too many assets have gone up together in the past few months, but it's impossible to say how long that will last or what is currently overvalued right now. That's perfectly fine, though, as the Hedgewise risk algorithms have continued to catch major events and short-term swings will have little impact by the end of the year.

More importantly, Hedgewise has already driven significant gains for clients in 2017 and beaten most major benchmarks, and I fully expect that trend to continue.

Disclosure

This information does not constitute investment advice or an offer to invest or to provide management services and is subject to correction, completion and amendment without notice. Hedgewise makes no warranties and is not responsible for your use of this information or for any errors or inaccuracies resulting from your use. Hedgewise may recommend some of the investments mentioned in this article for use in its clients' portfolios. Past performance is no indicator or guarantee of future results. Investing involves risk, including the risk of loss. All performance data shown prior to the inception of each Hedgewise framework (Risk Parity in October 2014, Momentum in November 2016) is based on a hypothetical model and there is no guarantee that such performance could have been achieved in a live portfolio, which would have been affected by material factors including market liquidity, bid-ask spreads, intraday price fluctuations, instrument availability, and interest rates. Model performance data is based on publicly available index or asset price information and all dividend or coupon payments are included and assumed to be reinvested monthly. Hedgewise products have substantially different levels of volatility and exposure to separate risk factors, such as commodity prices and the use of leverage via derivatives, compared to traditional benchmarks like the S&P 500. Any comparisons to benchmarks are provided as a generic baseline for a long-term investment portfolio and do not suggest that Hedgewise products will exhibit similar characteristics. When live client data is shown, it includes all fees, commissions, and other expenses incurred during management. Only performance figures from the earliest live client accounts available or from a composite average of all client accounts are used. Other accounts managed by Hedgewise will have performed slightly differently than the numbers shown for a variety of reasons, though all accounts are managed according to the same underlying strategy model. Hedgewise relies on sophisticated algorithms which present technological risk, including data availability, system uptime and speed, coding errors, and reliance on third party vendors.

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