Going Broke in 2018

16th Jan '19 by Gromley

6 comments 1561 reads

Performance review for hedged "Brokefolios" 2018

Last year I set out on an experiment to create “market neutral” portfolios by hedging Ed Crofts NAPS (&SNAPS) portfolio with a diversified portfolio of short positions selected using the NAPS methodology “in reverse”.

With a rather weak pun on SNAPS I named these the Brokefolios.
In this piece I’ll lay out the results and some of the learning picked up along the way.

You can read more about the original idea (as well as the half year review) here

At the outset I derived two separate Brokefolios; firstly the “Man for Man marking” folio (M4M), which selected a stock in each industry group within the NAPS portfolio and secondly the “Zonal defence” using the standard diversification rules I had set out.

I also chose to compare half year rebalancing with the full year view. With the benefit of hindsight, that’s just too complex – I am now tracking four different short portfolios and theoretically eight different hedged portfolios. I will therefore keep these results quite condensed.

Anyway ,moving on.

High Level Results

Just in the first table I am showing the results of being “long” each of the portfolios in question. The second table shows the results of the composite Long/Short folios.

The main observation here is that there is not a great deal of difference between performance of the short or long portfolios in the second half of the year. (The original M4M was down more steeply than the others in the second half, by virtue of not having any outlying stocks that rose significantly.)

This is mildly disappointing.

The balanced portfolios mostly made a small loss in the second half, compared with the horrible performance of the long portfolios and even after considering the extra costs involved in running the hedge performance would still be nicely ahead. (Or should I say less behind?)

But is that outperformance sufficient to compensate for the inevitable underperformance when NAPS is roaring ahead in a bull market?

It looks like case unproven, although I am still positive about this approach. I’ll leave my reasoning on that to the end as some of the following points have bearing.

The Bad and the Good

Although the idea here is really about a diversified portfolio and strategic ignorance (it’s difficult…

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Nick Ray

16th Jan '19

The problem with the long-short approach is that when NAPS like systems start to fail they seem to fail by losing the ability to discriminate. If the same thing happens to the short portfolio then it too reverts to the median and fails to maintain the difference that you are looking for, which seems to have happened in this case.

That maybe suggests that simply shorting an appropriate index (assumed to give median performance) might work just as well.

It is definitely true that the market volatility is reflected across all stocks in all the performance deciles (i.e. they tend to wriggle up and down together.) But against this, you tend to remove the beta component from your portfolio when times are good. And the beta component is a significant fraction of your gains.

mmarkkj777

17th Jan '19

Hi Gromley,

A really interesting exercise. As you know I have been playing with the concept of a short-long strategy.

I didn't formulate the plan prior to October's correction, so ended up mainly in cash (via stops and manual sell decisions). Since November, however, I have been using a 2xshort ETF (SUK2) to hedge on a daily basis, on the bad days (always closing the short position at the end of the day). As Nick mentions above, it works to an extent and certainly takes the sting out of a bad day. I just need half the value of my portfolio in cash to use for the hedge.

Obviously, I have to do this on an on-off basis as the market can be fickle and change at any point (and some days I loose more on the costs than I save; but not many days). The other issue is that its an FTSE100 short tracker and many of my stocks are AIM listed, so it doesn't always exactly correlate. I'm going to persist with this for a while, as it is relatively easy to switch on and off.

Be interesting to compare notes at year end.

Cheers,

Mark.

But how do you know whether it is going to be a "bad" day and need shorting at the start of the day?

Hi Nick,

Well, Not very scientific, but there is often a 0.2/0.4% jump in the index at the start, so I wait about 30-45 mins, then if the index is falling after that, I put my short on. If it reverses, and heads north, I turn it off again (obviously allowing for a bit of noise).

I don't want to start betting on the index per se and only use it to take the sting out of a bad day. You know the days, sentiment is down, the Dow and S&P had had a bad afternoon. I also look at the FTSE Futures index (but this can be red herring), so mainly I use my eyes and watch actual index and react rather than try to predict. I also think it has helped me get a better feel for the market. I'll know better over a longer period. I'm still learning.

Gromley

Interesting thoughts, thanks both.

On the subject of whether it might be better just to use an index short, I have two main considerations.

1. Although the StockRanks did appear to be less discerning in the downturn (and probably will again), they didn't entirely lose their power. Although the difference between my folios and the NAPS in H2 was pretty small, I've a hunch that part of that was "unlucky" selections. If you look back to the broader SR groupings 80-100 (-14%) vs 0-20 (-25%) there was still a pretty good level of differentiation. In fact the FTAS was down only 12.5% (I think as mentioned elsewhere that is because Larger Caps held up better than Smaller Caps).

2. On the other side of the cycle, I plan to continue this approach into the next bull market (unless absolutely convinced of the market direction). In such a market I expect that natural order of things to more firmly reassert itself (Low SRs will underperform 'the market' which will underperform High SRs). I would not want to use a market index as a hedge in a bull market. I did briefly have a look at this about a year ago and I found that even in the good years, there were significant periods of time when the NAPS barely did more than track the market.

There is in fact a third 'benefit' and that is that I think I'm learning quite a lot from the process and perhaps I might find the next Microsoft lurking in my rag tag bag of story stocks (not that I'm holding my breath).

Of course hedging via an index is easier.

Although not perhaps if you do it mark's way!

I'm fascinated by what you are doing there and it would be really interesting to understand how it pans out.

One cheeky question though; if you prove to make it work, why wouldn't you just become a day-trader?

Hi Gromey,

Well, to answer your question about becoming a day trader, my answer is because it goes completely against my investing ethos and logic. It's no surprise to me that over 85% of day traders lose money.
Lack of diversification. Market is fickle, high costs with spreads and (possibly) stamp duty. I could imagine its very difficult to make money, and I'm trying to improve my performance!!

Using a short tracker x2 as a bad day hedge is really not that difficult. If the market is rising I don't use it. If it is falling after the first half hour after the bell, I use it. Its on the days that I think the market will tank and it doesn't that I can lose my dealing costs, but then my stocks have risen (so the cost is some lost gains, for a short period of time). Its not a daily thing, just an alternative to selling stocks with the costs involved. The fund has a re-balancing cost if you hold overnight.

It won't make me money in a falling market, but hopefully it will continue to help me to lose a lot less on days it falls. Most of the time I wont use it because the market rises more than it falls (and sometimes just moves sideways), and in a Bull market it will be under-utilised and my gains will be normal (one of the main drawbacks of hedging).

Going Broke in 2018

Performance review for hedged "Brokefolios" 2018

High Level Results

The Bad and the Good

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Gromley

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