Hedging Isn't E'er Better

Many of the strategies I wrote nigh inward this spider web log are market-neutral strategies: long i musical instrument as well as brusk exactly about other i every bit a hedge. In many hedge funds, these are the exclusively strategies that are allowed: investors imagine that exclusively market-neutral hedge funds tin deliver consistent returns inward bull as well as acquit markets alike, as well as the typically smaller drawdowns experienced past times such funds let them to obtain higher leverage from their prime number brokerages. However, over the years I receive got expire convinced that this bias inward favor of marketplace neutral strategies is misplaced inward several ways.

First off, it is a fleck dizzy to operate difficult to uncovering a market-neutral strategy as well as hence that nosotros tin receive got a smaller drawdown as well as hence that nosotros tin increase its leverage to boost its return. After all these leveraging, the drawdown is oftentimes dorsum to the same degree every bit a long-only strategy! Why non exactly run a long-only strategy at a lower leverage, but that is oftentimes simpler inward blueprint as well as that incurs lower transaction costs (since at that spot is exclusively one-side of the merchandise to execute)?

Secondly, at that spot is a misconception that long-only strategies volition certainly lose coin inward acquit markets. This is in all probability truthful when you lot are asset overnight -- but long-only day-trading strategies are oftentimes profitable inward both bull as well as acquit markets.

Thirdly, at that spot are strategies where exclusively the long trades work. Influenza A virus subtype H5N1 unproblematic instance is a strategy that buys an index at its 10-day low, as well as move out when... well, at that spot are multiple ways to move out as well as most of them work! If you lot effort the mirror icon of this strategy, i.e. brusk an index at its 10-day high, it industrial plant far less well. This exactly reflects the positive hateful render of the equity market, as well as why non receive got wages of that?

Finally, related to the 3rd point, sometimes the brusk hedge fails exactly because the brusk musical instrument is truly quite unlike inward nature than the long one, despite their superficial similarity. An example is provided past times Mr. Sandy Fielden at Logical Information Machines. There is a normally profitable merchandise where you lot long a May gasoline futures contract as well as simultaneously brusk a May heating petroleum contract inward the spring. The logic is that every bit the weather condition gets warmer, the driving flavor volition laid about which drives the toll of gasoline futures up, as well as the need for heating volition decrease which drives the toll of heating petroleum futures down. This hedged merchandise is supposed to eliminate full general liberate energy marketplace risk. However, the weather condition is sometimes unpredictable, as well as inward 2005, this merchandise went quite incorrect primarily because the wintertime lasted longer. On the other hand, if you lot exclusively move inward the long side of this trade, i.e. purchase gasoline futures inward the spring, it industrial plant similar a charm every twelvemonth inward the past times 10 years! (I receive got posted a detailed analysis of this long-only gasoline futures merchandise inward my Premium Content area.)

Therefore, if you lot merchandise for yourself as well as non for exactly about institutions alongside a mandate exclusively for market-neutral strategies, at that spot is no bespeak to live bounded past times the same rules that they receive got to play by.