Market Timing And Hedging: All Sectors Are Not Equal

Market timing usually improves the risk-adjusted performance of a stock index on the long-term. The improvement may be a higher return, or a lower volatility, or a more acceptable drawdown, and often the three (article here). But for a specific stock portfolio, the decision to go to cash, to hedge, or to do nothing depends on various factors: investment style, liquidity, position size, selection criteria, and also sectors.

To illustrate this, I will use an extract of a personal research on the relations between a set of fundamental factors, sectors, market capitalization segments, and stock prices. For each sector, I defined a specific ranking process. For example, my S&P 500 Consumer Staples ranking process uses three fundamental ratios (it won't be detailed here - the aim is to measure the impact of protection tactics on a reference portfolio). I will use a strategy consisting in buying or holding every 4 weeks the ten stocks of highest rank in S&P 500 Consumer Staples. My purpose is not an optimal strategy, but something based on common sense and hard data to model a portfolio of "good companies" in a sector.

I have performed three 15-year simulations (1/1/1999-11/29/2013): without protection ("NP"), with market timing ("MT") and timed hedged ("TH"). The portfolio is rebalanced every four weeks. The timing indicator is the same for market timing and timed hedging. It is defined by a bearish signal when the S&P500 current year EPS estimate falls below its own value three months ago, and a bullish signal when it rises above this value. This is an aggregate fundamental indicator. There is no technical analysis here. The hedge is a S&P 500 short position in a 1:1 ratio with the portfolio value (for example buying SH).

The next table shows simulation results. Dividends are included. A 0.1% rate is applied for transaction costs. A 2% annualized carry cost is applied for temporary hedging positions.

SP500 Strategies	Annualized Return	Drawdown	Volatility	Sortino	Correlation/S&P500
Staples-10best-NP	18.0%	-27.0%	19.1%	0.99	0.59
Staples-10best-MT	13.6%	-14.2%	12.7%	0.92	0.32
Staples-10best-TH	22.9%	-29.3%	19.6%	1.33	-0.17

Stocks in this defensive sector hold very well even without protection. In fact, the non-protected version gives a better risk-adjusted performance (Sortino ratio) than the market timing version. It also gives a lower risk (drawdown and volatility) than the timed hedging version. But the timed hedging version gives the best annualized return and Sortino ratio, and also the lowest correlation with the benchmark index.

The turnover is quite low: on average 1.4 stock changes every four weeks.

Here is the equity curve of the strategy without protection (in red) compared with the S&P 500 index (in blue):

(Click to enlarge)

This is a dynamic portfolio based on quantitative data. Current holdings are of minor interest for the demonstration. Nevertheless, to make the example realistic, here is the list at the time I write this:

Dr Pepper Snapple Group (DPS), Kraft Foods Group (KRFT), Lorillard (LO), Altria Group (MO), Philip Morris International (PM), Reynolds American (RAI), Constellation Brands (STZ), Molson Coors Brewing (TAP), Tyson Foods (TSN), Wal-Mart Stores (WMT).

The conclusion is that usual market timing rules might not work for a portfolio in the Consumer Staples sector. Timed hedging may bring a better performance and a lower correlation with the benchmark. Results can be different with another timing indicator, and past performance is not a guarantee for the future. My next article will evaluate the same protection tactics in another sector. Click on "Follow" if you don't want to miss it. Links to additional information sources can be found in my Seeking Alpha profile.

Source: Market Timing And Hedging: All Sectors Are Not Equal

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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