Contact Us
Hedgewise advisors are available to every potential client because you deserve to know and trust who is managing your money.
E-mail
Questions / Comments
SUBMIT
X CLOSE
Investments That Outperform
Thanks! Only $1,000,000 remaining.
You can help accelerate launch by referring a few friends.
X CLOSE
PERFORMANCE ABOUT BLOG LIVE 510-876-9473
CLIENT LOGIN
PERFORMANCE
ABOUT
BLOG
DEMO
CONTACT US
TOPICS
About Us
|
Account
|
FAQ
|
Investment Strategy
|
Market Commentary
|
Can You Time Risk-Managed Strategies?
Posted in Investment Strategy on 2018-04-17

Summary

  • Many clients wonder whether they should adjust their approach depending on market conditions
  • However, risk-managed strategies are constantly responding to the current environment, such that attempts at timing are usually counterproductive
  • After a quick review of why this is consistent with the underlying theory, I'll analyze a few of the most common "timing" questions to see if they have any merit:
    • Should I wait to put cash to work until after a period of large losses?
    • Should I take cash off the table after a period of large gains?
    • Should I invest elsewhere if I think an equity or bond bear market is approaching?

Risk Management versus Timing

If inflation, trade wars, data leaks, slowing global growth, or government instability has given you pause on the investment outlook, you are certainly not alone. It's hard not to wish that you had just sold everything in January, or not to wonder whether you should still sell everything now. The good news is that Hedgewise frameworks have already shifted to account for these market conditions, and the future outlook remains excellent. The bad news is that you will still likely wonder whether you can time it better yourself, but fortunately we can look to the theory and data for guidance.

While Hedgewise runs two different risk-managed frameworks - Risk Parity and Momentum - they are rooted in the same core financial principles:

  • Investors generally expect a positive return on their investments, so in normal environments, markets appreciate over time
  • Diversification across different kinds of assets, like stocks and bonds, reduces risk by offsetting short-term gains and losses
  • As market risk goes up, so does the probability of large gains or losses

Hedgewise then uses financial engineering, like leverage and risk balancing, to most effectively apply these concepts to its products.

Note that none of these principles require you to figure out whether assets are over- or under-valued, which tends to be incredibly difficult. This kind of "timing" usually backfires because it requires that you know the exact right time to enter or exit. One of the main reasons that risk management is effective is because it avoids the need for such precision.

When relying on the relatively simple principles above, the focus shifts away from short-term returns and towards long-term stability and loss reduction. When this is done intelligently, it means your portfolio is constantly maximizing the odds in your favor. Positive returns are always more likely than not, even in the worst of market conditions.

Clients often find this counterintuitive because 1) it seems impossible that return expectations would be positive if markets are about to collapse, and 2) risk-managed strategies still undergo periods of loss, which in theory might be timed. However, because these periods of loss are driven by the relationships between different assets and their volatilities, they often have little to do with bear markets. For example, both Risk Parity and Momentum wound up with calendar year gains during four of the last five major stock crashes.

Put another way, to time a risk-managed strategy, you'd need to be able to predict when fundamental asset relationships and risk indicators are about to breakdown in conjunction with a major market crash - a tall order indeed! These kinds of events tend to be quite sudden, random, and short-lived by definition.

Now, it is true that the probabilities of gain or loss do shift in certain market conditions - for example, you have a better than normal chance that risk-managed strategies will do well after a period of loss. But in waiting around for a loss to happen, you'll probably miss substantial gains in the meantime. No matter which way you cut the scenario, the same theme arises: it's tremendously difficult to beat the simple approach of buy-and-hold.

Scenario 1: Waiting for a Loss

It's far easier to invest with confidence when assets look cheap, and many prefer to wait on the sidelines until after some kind of crash. This is always a tricky topic because, in hindsight, it's true that you make more money if you buy low, and cash also carries great comfort for the risk averse. The problem is that risk-managed strategies are hedged across many different kinds of assets, so a crash in a single market often doesn't result in net losses to the portfolio.

As an illustration, here are the rolling 1yr returns since 1972 for Risk Parity High, Momentum High, and a 50/50 split between the two.

1yr Rolling Returns By Strategy Since 1972

Data based on hypothetical models using end-of-day index data since 1972. All dividends are included and assumed re-invested. Includes an estimate for Hedgewise fees of 0.7%. See full disclosures at end of article.

Depending on your strategy mix, you've historically had about a 6-10% chance of incurring a loss over the following 12 months, or conversely a 90-94% chance of incurring a gain. Most of these losses were also fairly minimal; there was a less than 2% chance of incurring a loss of 10% or more.

That said, you may still figure that waiting for one of these periods still bumps your odds up further, and you'd be right: if you happen to start after a twelve-month loss, your historical odds of a subsequent gain go up to over 98%. But the question is not whether the odds improve, but rather if it makes sense to wait around for that to happen.

A simple way to answer this question is to calculate a "breakeven point" in time. That is, the date where the gains you would have accrued before the subsequent drawdown were greater than the drawdown itself. This assumes that you also had the magical ability to invest right at the exact bottom of each pullback. Performance is drawn from the 50/50 split portfolio (though RP/MM alone show similar numbers).

If you got in at the exact bottom in.. You'd still be worse off than if you started..
Jun 19787 months earlier
Sept 198117 months earlier
Jun 19848 months earlier
Aug 198823 months earlier
Sept 19905 months earlier
Nov 199417 months earlier
Aug 20012 months earlier
Jan 20164 months earlier
Data based on hypothetical models using end-of-day index data since 1972. All dividends are included and assumed re-invested. See full disclosures at end of article.

On average, you lost about 10 months' worth of gains. In other words, to successfully take advantage of an upcoming period of losses, you need to a) correctly identify the 10% chance that losses are going to occur at all, b) be pretty sure it's not more than 10 months away, and c) know exactly when the drawdown hits bottom. If you fail on any single one of these conditions, you'd be better off investing now rather than waiting.

That said, there are understandable exceptions: you may keep a discretionary pool meant for more opportunistic investing, you may have new savings become available at a distinct point in a year, or you may be quite confident in your ability to foresee an upcoming loss. In these cases, you'd like to know when the probabilities for a near-term gain are the most favorable.

One way to study this is to compare the size of any current drawdown in the strategy framework to the subsequent returns. Performance is drawn from the 50/50 split portfolio, but RP/MM alone again show similar numbers.

Forward Return of the 50/50 Split Portfolio for Various Timeframes, by Size of Drawdown

Data based on hypothetical models using end-of-day index data since 1972. All dividends are included and assumed re-invested. See full disclosures at end of article.

Interestingly, even drawdowns as small as 3% substantially increased the size of future returns. While it might seem tempting to wait and capitalize on the bigger losses, they are extremely infrequent: the last 15% drawdown happened in 1988. A more reasonable target would be anywhere in the 5-10% range, which you'll usually see every other year or so. But remember, if you sit in cash for more than a couple of months, you'll probably miss more gains than even a successful timing attempt will recoup.

Applying this analysis to today, we experienced a drawdown in the 50/50 strategy of around 10% from January 26th through February 8th. Historically speaking, there's around a 95% chance we are already past the bottom. While there's been some recovery since then - the current drawdown is now more like 7% - it is still quite an attractive time to invest if you happen to be sitting on cash.

Scenario 2: Selling After Gains

Looking back, it seems obvious that the initial fast gains in January were signs of overheating, and to wonder whether there was a way to identify that beforehand. However, nothing in the underlying theory suggests that gains of a particular size or speed should be worrisome. After all, we expect gains to happen 90% of the time, and the techniques of hedging and risk management are always limiting the impact of an individual asset bubble or crash. To test this, we can compare short-term gains in the 50/50 strategy to subsequent historical returns. To further isolate "overheating" scenarios, this data is also limited to months in which there was no recent drawdown.

Forward Return of the 50/50 Split Portfolio for Various Timeframes, by Size of Prior 1 Month Gain

Data based on hypothetical models using end-of-day index data since 1972. All dividends are included and assumed re-invested. See full disclosures at end of article.

This data shows no indication that large gains typically precede losses. In fact, quite the opposite: forward-looking returns often increase instead! Digging into the numbers, it is unsurprising to learn that you see clusters of great returns in the middle of broad, calm bull markets - years like 1997, 2006, or 2017. In these periods, when you had a fantastic one-month gain, you typically went on to have many more of the same. This same pattern shows up using prior three-month, six-month, and one-year gains as well; there's simply nothing to suggest that big positive returns frequently reverse.

If a risk-managed strategy is implemented well, this is what you'd expect. While individual asset classes like equities may become "irrationally exuberant", such risks are explicitly built into the frameworks and minimized. Though occasional drawdowns are inevitable, they tend to be quite random, and certainly have nothing to do with recent performance trends.

Scenario 3: Timing Bear and Bull Markets

The final timing question that many clients wonder is: what if it is just a bad time to be invested in general? For example, if you knew that bonds and/or stocks were going to do poorly for the next year, wouldn't you be better off exiting?

Even if you had the ability to correctly forecast an upcoming downturn, that wouldn't necessarily mean that risk-managed strategies make a bad investment. Returning to the theory, different asset classes will perform differently depending on the underlying economic environment. For example, in a recession, gold and bonds will tend to rally while stocks will tend to fall. So long as these relationships hold up as expected, risk-managed strategies should be quite resilient against individual asset crashes.

To test this, we can examine the performance of the 50/50 split portfolio in the worst-performing stretches for both stocks and bonds. Starting with equities, the following table displays tranches of every rolling one-year period of losses in the S&P 500 since 1972 and summarizes how the 50/50 split portfolio performed over the same periods. Note that the "% Gain" and "% Loss" columns display the number of data points when the 50/50 portfolio had either a gain or loss out of the total number of data points within tranche.

Rolling 1yr Performance of the 50/50 Split Portfolio During Equity Drawdowns

50/50 Split Performance
S&P 500 1yr Loss Avg.% Gain% Loss
0-5% Loss +5.4% 67.7% 32.3%
5-10% Loss +4.3% 69.6% 30.4%
10-15% Loss +7.6% 87.5% 12.5%
15-20% Loss +9.8% 90.9% 9.1%
20-30% Loss +8.7% 94.1% 5.9%
Over 30% +14% 88.9% 11.1%
Data based on hypothetical models using end-of-day index data since 1972. All dividends are included and assumed re-invested. See full disclosures at end of article.

In every single tranche, you averaged gains in the 50/50 split despite losses in the S&P 500. Your odds of a gain also significantly increased along with the size of the equity pullback. This is because risk-managed strategies tend to minimize equity exposure as losses increase, while safe-haven assets like bonds and gold rally. In fact, the strategies tend to be most vulnerable to "small" losses (under 10% or so) that occur when the market is still trying to "figure things out". For example, in our most recent pullback, bonds and gold have not rallied much despite the pullback in equities because it is not yet certain that a recession is imminent. Of course, these short periods are all the more difficult to time!

Now let's repeat these same numbers for bonds to make sure the story is consistent. Note that the loss ranges had to be reduced compared to equities as bonds are far more stable.

Rolling 1yr Performance of the 50/50 Split Portfolio During Bond Drawdowns

50/50 Split Performance
10yr Treasury 1yr Loss Avg.% Gain% Loss
0-1% Loss +10.2% 87.5% 12.5%
1-2% Loss +13.5% 88.2% 11.8%
2-3% Loss +16% 93.3% 6.7%
3-4% Loss +14.1% 91.7% 8.3%
4-5% Loss +12.9% 83.3% 16.7%
Over 5% +9.2% 74.3% 25.7%
Data based on hypothetical models using end-of-day index data since 1972. All dividends are included and assumed re-invested. See full disclosures at end of article.

Bonds exhibit a similar story, though you do see slightly lower (albeit positive) returns for losses of over 4%. Many of the data points in this upper range come from periods of high inflation, during which both stocks and bonds tend to do poorly while commodities provide a hedge. This presents less opportunity for net upside as commodities are naturally a smaller portion of the portfolios. At worst, though, you averaged a 9.2% annual return and a 75% chance of gains.

Summing up the numbers, it really didn't make sense to avoid risk-managed strategies even if you had perfect insight about upcoming equity and bond pullbacks. Your worst-case returns were around 4-5% during smaller equity pullbacks, while in all other cases you achieved returns of 8% or more. Those are pretty stellar numbers in years of very rocky markets.

Conclusion: Staying the Course, Expecting a Few Bumps

Put simply, risk-managed strategies are really effective at dealing with worst-case scenarios. They assume that bubbles and crashes are part of the norm, but since this logic is already built-in, you can't apply traditional thinking like how to "get out at the top" or "get in at the bottom". Neither a stock crash nor a bond crash will necessarily result in losses; more often, the portfolio is vulnerable to quick pullbacks or markets that have a great deal of uncertainty. Even if you could time these situations, the losses are usually pretty small and not worth the headache of figuring out when to re-enter. If you try to time unsuccessfully, the gains you miss quickly outweigh any potential benefits.

None of this is to suggest that these frameworks are invulnerable, but rather that the probabilities are enormously in your favor if you invest early and stay patient. You will certainly have a few situations where this patience is tried: you may underperform the S&P 500 for stretches of time, hedges will fail to work in certain situations, and markets will sometimes be blindsided by the unpredictable. Despite all of that, there is an extraordinarily high chance that you will go on to perform wonderfully if you simply shrug your shoulders.

For discretionary pools, you've generally found good entry points during drawdowns of 5-10% or during periods of consistently large gains, regardless of surrounding market conditions. That said, if you don't currently have better uses for your discretionary funds, or if in reality you are just trying to optimize the entry point for your broader portfolio, the best path is almost certainly the simplest: invest now at your long-term risk level, and don't worry about the timing.

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.

February 2018: Why Not to Panic When Markets Go Crazy
Posted in Market Commentary on 2018-02-12

Summary

  • Hedgewise has incurred losses of 5-10% since late January, depending on your product and risk level, but is only down slightly year-to-date and continues to outperform all major competitors.
  • Much of the drawdown has been driven by simultaneous losses across all asset classes, which strongly suggests investor panic and confusion. Such scenarios have never lasted long historically and will likely soon reverse.
  • Even if some of the worst-case scenarios come true, like stronger than expected inflation or a recession, both Hedgewise frameworks have held up well in such environments.

Stay Calm and Carry On: Putting Recent Losses in Perspective

Make no mistake: markets have been pretty wild for the past couple of weeks, and if it's started to make you nervous, you are human after all! It has been especially confusing because the swings are quite hard to explain: not all that much has changed in the economy since January, yet markets are suddenly terrified of inflation, government debt, volatility, and valuations. If you can't explain why people are selling now, it's also hard to predict when they will stop.

Since every investor on the planet has this same logic and fear, it's easy to see how it can all quickly turn into a frenzy. And yet, this story also justifies why short-term market volatility shouldn't worry you much at all. If people are panicking for no good reason, you can be almost certain that they are selling assets too cheaply, and that's really the worst possible time to change your approach.

It helps to return to the basics of investment theory, which I discussed in my previous newsletter. Recall that your expected returns should look something like the following, with the blue line being your realized month-to-month returns, and the orange being the underlying "risk premia" - or "fair value" - that you are accumulating over time.

If you look at the past two weeks or so, we've most likely just experienced a very rapid cycle of this diagram, with assets moving temporarily above their fair value and now back below. The reason this is not particularly concerning is that it has no effect on your expected return over time, so long as you simply wait. By focusing primarily on long-term returns, you also minimize the many pitfalls of short-term timing and active management.

Now, Hedgewise still applies various kinds of risk management, but it is all with this long-term focus. For example, balancing exposures across many different assets, like stocks and bonds, tends to minimize the impact of a crash in any single one. But in the span of a few days or weeks when investors are panicking, it is possible they will all move down together. Likewise, there are certain extreme risk environments, like recessions and hyperinflation, that can sometimes be detected beforehand. But short-term market swings most often have very little to do with the economy at all.

With this perspective, the Hedgewise frameworks have continued to be quite effective. For example, since the beginning of 2018, the Hedgewise Risk Parity framework has lost significantly less than comparable major mutual funds. This continues a clear trend of outperformance ever since Hedgewise was launched. Last year, the Hedgewise Risk Parity and Momentum products both significantly outperformed the S&P 500 at the Max risk level, yet neither has lost significantly more than the S&P 500 so far this year.

Periods like these past two weeks will always be uncomfortable, but short-term losses are very different than long-term risk. To further make this case, let's take a deeper look at recent performance trends and how they stack up against history.

2018 Year-to-Date Performance: Unavoidable Losses, But Better Than the Competition

While most of the news is focused on stock returns since the peak on January 26th, equities were up almost 8% before they gave it all back. Trying to make sense of this fast of a reversal doesn't serve much purpose. The more interesting story is how various asset classes have performed year-to-date overall:

2018 Year-to-Date Performance By Asset Class

Hedgewise data based on various end-of-day index prices and include an estimate for all dividends. Data as of Feb 9th, 2018.

The bond market has actually been in a more significant correction than equities, as long-term yields have jumped about 0.7% since last September and 0.5% in the past two months alone. This makes some sense, given the Fed has started to more rapidly raise rates and reverse the "Quantitative Easing" program, and Hedgewise risk indicators have been frequently spiking as a result, including last month. The effectiveness of this dynamic risk management can be most easily seen by comparing the performance of the major Risk Parity mutual funds.

Performance of Hedgewise RP High vs Major Risk Parity Mutual Funds, 2018 Year-to-Date

Data based on publicly available quotes for AQRNX and ABRYX and include an estimate for all dividends. Hedgewise data is an average of all client performance in the RP High product and includes all costs and fees.

The graph continues to demonstrate a high correlation between the various risk parity products, since they are all investing in the same broad asset classes. The main difference is in how risk is balanced, and Hedgewise has consistently achieved a superior level of performance in the short and long-term, as demonstrated by its comparative performance back through the beginning of 2017.

Performance of Hedgewise RP High vs Major Risk Parity Mutual Funds, 2017 to Current

Data based on publicly available quotes for AQRNX and ABRYX and include an estimate for all dividends. Hedgewise data is an average of all client performance in the RP High product and includes all costs and fees.

While the relative performance is excellent, why hasn't any Risk Parity framework been able to better hedge this equity correction? If you glance back at the year-to-date performance across asset classes, you'll notice that bonds, commodities, and stocks have all incurred losses simultaneously. In such an environment, there's really no way to avoid a loss unless you engage in very short-term timing (quick reminder: all active managers do some form of this, and over 90% of them underperform the S&P 500).

This kind of cross-asset correlation is somewhat exceptional, especially during a 10% equity correction, though not entirely unprecedented. Since 1970, there's been exactly four other scenarios where equities have lost 8% or more while safe havens like gold and bonds also suffered losses.

DateEvent
Jul 1974Beginning of Stagflation
Dec 1980End of Stagflation; Interest rates peak near 20%
Oct 2008Beginning of Great Recession
Mar 2009Great Recession Market Bottom

While these are some pretty scary events, the good news is that Hedgewise frameworks still did fine in all of these scenarios because safe havens eventually kicked in. Let's take a deeper look at how it unfolded.

When Safe Havens Fail: Why It Happens and What It Means

There are only two reasons that investors sell stocks, bonds, and commodities at the same time: either they are in full panic, or they are really confused about inflation. The Great Recession was a great example of 'sell everything' when Lehman went bankrupt. People just moved to cash in a mix of confusion and a need for liquidity. Gold was the logical hedge against a failing financial system, and it went on to rally by 30% by February 2009, but it often won't hold up at the outset.

Stagflation is the other culprit, since it means poor economic growth due to runaway inflation. Both stocks and bonds will lose money by definition (since higher inflation means higher interest rates). While real assets like commodities should do well since the dollar is losing its value, there's often an initial fear that the Fed will pre-emptively raise rates to fight inflation even if it will result in a recession. Ironically, a recession would then mean lower interest rates, so then bonds would actually rally, but you can see how everyone basically gets scared and confused!

In each of these scenarios, equities, bonds, and gold all fell together for a couple of weeks. To see how it eventually played out, though, I looked at the full one year return for each asset class following each event.

One Year Return by Asset Class After Initial Event

Date Stocks Gold Bonds
Jul 1974 15.2% 16.4% 5.6%
Dec 1980 -2.8% -36.6% 11.6%
Oct 2008 -9.2% 14.1% 7.7%
Mar 2009 62.3% 18.8% -2.7%
Data based on publicly available end-of-day index prices and include an estimate for all dividends assumed re-invested.

What's really neat is that you can see all of the different possibilities unfold. While these were all pretty awful economic times, at least one of the asset classes eventually rallied. It's the laws of economics at work.

It's also helpful to look at how the Hedgewise models did over this same one year period after each initial event.

One Year Return by Hedgewise Model After Initial Event

Date RP Max Momentum Max
Jul 1974 9.8% 14.3%
Dec 1980 -4% 41.5%
Oct 2008 20.4% 6.7%
Mar 2009 22.1% 38.2%
Hedgewise models based on hypothetical simulations using end-of-day index prices and assume all dividends are re-invested. See full disclosure at end of article.

The big idea is that markets work themselves out over time, and that is eventually captured in the Hedgewise frameworks. You can still wind up with some bad years, and performance won't always bounce right back. But the odds are always on your side, perhaps even more so right after the scariest kind of market behavior.

Wrapping Up

While hopefully it's clear that there's no need to panic, whether losses have already bottomed or not, these past couple of weeks are still a wonderful opportunity to reflect on your own goals and risk tolerance. Investing presents a natural conflict between logic and fear. Rationally, targeting a higher long-term return seems like the right choice for many clients, despite the warning that a 20-30% loss is basically inevitable at least once a decade (at the higher risk levels). Yet it can feel quite different in the past couple of weeks when you see 10% disappear, and that's not even a particularly severe event!

On the other hand, the RP Max and Momentum Max product returned about 27% and 31%, respectively, in 2017 alone. Even if losses continue and this is the year of a 30% drawdown, you'd only be slightly worse off than if you had held cash the past year. It all depends on your perspective. Whether next month or next year, the drawdown will eventually come. If you remain patient and calm, it will also almost certainly pass. Either way, this most recent experience should help prepare and inform you.

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
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.

Related Posts

Can You Time Risk-Managed Strategies? February 2018: Why Not to Panic When Markets Go CrazyHow to Link an Existing Interactive Brokers AccountHow to Link an Existing Interactive Brokers Account - New AMHow to Link an Existing Interactive Brokers Account - Classic AMAnalyzing Hedgewise 2017 Performance: Benchmarks, Timeframes, Theory and ProofQ3 Update: Hedgewise Outperforming Every Asset Class in 2017Understanding the Theory Behind Better ReturnsApril 2017: A Great Start to the Year2016 Year In Review: Hedgewise OutperformedHedgewise Systematically Avoids Bond CorrectionNovember Commentary: Election Risk Is Just Like Any Other Risk, And It Is Being ManagedHow to Open An AccountHow to Create Leverage Using Options ContractsHedgewise Outperforming Every Major Risk Parity Mutual Fund in 2016Risk Parity Just Got Even BetterWhat's Next for Risk Parity? 2016 Hedgewise Midyear Report: Choppy Markets, Big ReturnsThe Right Way To Invest In Oil Rising Interest Rates And Risk ParityThe Right Time to Buy Oil in 2016The Wrong Way To Invest In OilRisk Parity Outperforming the S&P 500 by 7% in 2016Risk Parity: Year-In-Review and 2016 OutlookWho We AreHow It Works: Faster, Cheaper, and More EfficientOur CustodianFeesWhy Commodities are the Smart Play for 2016Retirement Investing in a Rising Interest Rate EnvironmentComparing Hedgewise Risk Parity to the Competition Improvements to our Risk ModelSeptember 2015: Risk Parity Limits Losses, and the Upside of FearAugust 2015: Perspective on the Commodity CrashIs Gasoline the Smart Oil Play? (UGA vs. USO) 2015 Mid-Year Review: Understanding Unbalanced MarketsNavigating the Bond Market CorrectionFeeling Good About A Down MarketNew Account Set-Up - InvitationThe Optimal Gold Investment Strategy (Switching Between DGL and GLD)How Hedgewise Saved You Taxes in 2014This Is Why You Are Still Diversifying WrongThis Is Why You Are Diversifying WrongRisk Parity: What It Is, How It Works, and Why It MattersThe Financial Revolution Has Begun: 5 Bold Predictions for the Next DecadeMust Bond Investors Fear Rising Interest Rates? Insights From 1958 To 1982 The Oil Futures Curve Reversal: What You Need to Know5 Reasons Why You Should Be Afraid of a Bear Market, and How to Protect Your PortfolioHow to Invest in Oil for the Long Term, Avoiding Contango and Tracking ErrorTax Optimization and Tax HarvestingHedgewise FAQ