Hedged Convexity Capture

Hedged Convexity Capture Review

Disclaimer: Received a FREE copy of the book from the author (value $200), but did not get any money for this article or receive anything else as compensation. This seems like a very interesting concept worth understanding, but as always buyer beware. This strategy would be better suited to people who are comfortable with leveraged etfs OR just have a small allocation to it to try it out. This would probably be ideal complement to the “alternatives” asset class in your portfolio.

Reviewing “Hedged Convexity Capture”

There are very few true free lunches in the financial markets. A couple of ideas are conservatively selling option premium with limited risk (selling “time”) and selling index options that have higher historical implied volatility than usual (implied volatility mean reversion). Another idea is taking advantage of negative convexity in leveraged etn, such as TMV or TZA, which have a side effect of producing time decay over many months. Many of these products have 5 year histories now and some have lost more than 80% of their original value. However these have been have been too difficult to just long term short on their own, due to their periodic meteoric rises (even if ultimately they lose most of the spike and then some, you don’t typically want to be caught short on them).

This book You are Welcome, Planet Earth (yes, that is it’s real title!) gives an approach that takes advantage of etn products that have built in time decay, by combining them together to capture that negative convexity, but with a built in hedge (or “Hedged Convexity Capture”). The exact specifics are given in the book or in this series of Hedged Convexity Capture seekingalpha articles.

This high level article briefly looks at positive/negative points for this strategy and practical brokerage experience implementing the strategy.

Strategy Overview

The basic approach is combining pairs of etns to take advantage of time decay, while backtesting to get the appropriate % allocation to each etn.
You are essentially constructing a new “mini product” by combining etn pairs together (sometimes long/short or long/long). The strategy uses two decaying etns, where you take advantage of time decay in both positions, but one side is a typically hedge to the other (e.g. one stock etn, one bond etn).
Major advantage with a long/long pair is that if you use long only etns together, then your risk is truly limited to the money you add. However this still enables you to (for example) execute a “short implied volatility” view with defined risk (one long etn), which historically required higher margin and theoretical unlimited risk by being consistently short gamma.

The etn pair strategies are relatively simple to run, typically with only two positions (however could potentially backtest with more combinations). Only requires simple rebalancing for maintenance typically weekly or monthly.

Legitimate Questions

Isn’t this just curve fitting or data mining?
If you take any sufficiently large number of etn’s then you can come up with several combinations that make good pair trades on paper. This is true, but you have to filter the universe somehow, and having the time decay working for you gives a reason why the etn pairs appear to work (ie filter then backtest on decay etn combinations).

Isn’t this just fancy structured products? Isn’t that what got us into this mess in the first place?
Yes, but like any tool, it depends how you use them. There is no small irony that some traditional brokerages will let you buy $1 million SPY but may not let you purchase $10k of a long etn as part of a pair trade. Risk needs to be considered as positions aggregated together, not you cant buy any of X because is it too “risky” (even if is only a 0.1% allocation)

What! Why is there no backing testing before 2009 ?
Many of these products didn’t exist before that time, so this is a valid concern. The pre 2009 time series can be simulated using index data, and etn pairs given in the book would have to have to be back tested during credit crisis if that was a concern for you.

Doesnt rebalancing eat all your returns ?
Rebalancing can eat into your expected profit with commission costs. The stated annualized returns are in the region of 10% to 30% for some pairs, so this simply maybe a price to pay for higher returns. This is a concern and could potentially reduce annual returns by up to 2% depending on your commission structure, although several brokerages offer free online trades now. Some strategies needed weekly, some only monthly and some annual rebalancing.

Practical trading considerations

The beauty of the strategy is that it can theoretically be run in any standard long brokerage or retirement accounts. So how does that stand up in practice? Below were some brokerage issues encountered when trying to run the strategy with two “traditional” brokerages and two “trading orientated” brokerages. To be clear – this is more of an issue with the relevant brokerages, not the strategy itself. However it may require some verification with your broker before running these strategies, especially if they are more “traditional”.

One traditional brokerage had 2 issues:

- with shorting triple leveraged etn. This was blocked by the brokerage (not just “hard to borrow”). Etn was specifically not allowed by brokerage policy to be shorted both online and on phone.This could possibly be expected due to more complex margin requirements for shorting triple leveraged products, but would be allowed by typical “trading orientated” brokerages.
- One of the long etn products was blocked by brokerage policy from being bought long! This was pretty surprising as it is a totally legitimate long etn. The stated reason was expected market volatility of the product was unsuitable for most investors.

Therefore it was not ultimately possible to run one of the strategies with one of the traditional brokerages. The other traditional brokerage merely required signing a waiver to be able to buy or sell decay etns, along with a stern warning on the evils of such risky trading.
Obviously if it is not allowed in your traditional brokerage standard account, then it is likely blocked in retirement accounts too (but this was only tested with brokerage, not retirement accounts).
As expected the two “trading orientated” brokerages were fine.

Asset allocation in a portfolio

There are many alternative approaches to modern portfolio theory and 60% equity/40% bonds. People always talk about diversification, but rarely include strategy diversification. This is a non traditional strategy that aims to produce >10% returns, while not fully correlated to the traditional long only stock market. They are either correlated at less than 50% to is equities (SPY) or are correlated to market volatility.

This may be worth having a 1 to 10% allocation inside an existing diversified portfolio. A small selection of these etn pair trades (say 1 to 5 distinct ideas) could be run to represent the decided allocation. These strategies are worth considering because of the new types of risk measures (such as implied volatility) that they give exposure to. Traditionally these types of strategies have only been run by high net worth or institutional investors.

In summary, this is a strategy you may wish to have an allocation, but you would have to be comfortable with the historical trading history for each etn to understand what you are buying. However this style of qualitative structured etn pair strategy could be considered a new product or even ultimately a new alternative asset class.

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