Create Your Own Hedge Fund

Last time we covered the concept of leveraged short index funds, and looked at a few examples of them. Today we will cover the idea of building a hedged portfolio of mutual funds using one of the leveraged short funds as the hedging instrument. It's actually simpler than it looks.

You can build a hedge around an individual system. For example, for the Fundztrader ETF system we track, if, instead of holding and trading the 4 funds we suggest, if you were to hold those 4 funds and ad an equal holding of URPIX (Profunds Ultrabear) or SDS (the ETF clone recently introduced), the backtested results over the 5 years ending in September 2006 would have been:

Fundztrader ETF long system
Ann Return 26% Max Drawdown 36%

Fundztrader ETF hedged system
Ann Return 17% Max Drawdown 20%

As you can see, the annual return with a 20% holding as a hedge is reduced by 9%, but the MDD is reduced by 16%. The Ultrabear fund has a fairly large impact on the overall return, due not only to the fact that the S&P 500 was up slightly in this time period (about 7.6% per year including dividends) but there are also carrying costs associated with the overall short position that the fund has to pay.

So we want to use as small a hedge position as we can. Since we established before that we can reduced the overall risk with a diversified portfolio, we will be better served by hedging the total portfolio instead of the individual positions, since that allows a smaller hedging postion, and not as much reduction in the overall return.

The 3 Risk Mitigation Techniques Together

In our study of diversification, we built a portfolio of 4 funds, equally weighted, using 2 of the Fundztrader model portfolios as "fund" holdings. I'm going to fast forward a little bit through the entire portfolio building process, and suggest the following portfolio. This portfolio will use all 3 of our risk control techniques:

1) Market timing: we will use the Fidelity Seasonal System instead of the Fidelity Equity System. As you may recall, this is the same portfolio, but it goes to cash in the 3rd calendar quarter of the year

2) Diversification: We will use a portfolio of 4 "funds", the Fidelity Seasonal System, the Fidelity Select System, Fidelity Real Estate, and Fidelity Select Health Care. However, we are going to modify the allocation, so the 2 Fundztrader systems will be weighted at twice the other 2 Fidelity Funds

3) Hedging: We will add a holding of URPIX to the mix as well. It will be weighted the same as the 2 Fidelity funds.

So, here's the portfolio:

28.6%  Fidelity Seasonal System (FID4L)
28.6%  Fidelity Select System  (FIDO2)
14.3%  Fidelity Real Estate Fund  (FRESX)
14.3%  Fidelity Select Health Care Fund  (FSPHX)
14.3%  Profunds UltraBear  (URPIX)
Going through the same 11 years (1995 to 2005 inclusive), using the same quarterly balancing here are the results.

Ann Rtn MDD Std Dev
FID4L 22.5% 31.8% 16.7%
FIDO2 22.0 21.8 17.1
FRESX 15.0 28.2 16.4
FSPHX 14.1 42.2 20.7
Port 19.4 17.1 12.0
Hedged 16.3 8.2 7.1
Port = Previous long only Portfolio rebalanced quarterly 
  (25% each of the long "funds")
FID4L = Fidelity Equity Portfolio
FRESX = Fidelity Real Estate Fund
FSPHX = Fidelity Select Health Care Fund
Ann Rtn = Annualized return over the 11 years
MDD = Maximum Drawdown (our simple measure of risk)
Std Dev = Standard Deviation of the annual returns, another measure
of risk
So, by adding the hedge, we've given up about 3% of annual return, but we have improved the ann return to MDD ratio to about 2:1, and the Ann Return to standard deviation by about the same amount. The MDD is under 10%, or about 10 times better than the Nasdaq did from 2000 to 2002.

That is powerful stuff. Note, this is backtested. It's not real time, and there's no way to guarantee that we will see similar results in the future. But we built this portfolio using some time tested principles:
  1. Build the primary holdings using straightforward sector selection and rotation
  2. Lighten our holdings during historically unfavorable times of the years with the Seasonal system
  3. Reduce portfolio risk using uncorrelated funds, and REBALANCE quarterly
  4. Guard against market surprises with a moderate hedge.

These are techniques that you can use on your own as well.

Creating wealth trading mutual funds.

No fancy market timing.
No daily jumping in and out of the market.
No watching CNBC every hour of the day.
No chart reading.
No fund stars ratings.
No fundamental analysis.
No tracking earnings announcements.

You can do it. It's not as hard as everyone makes it look.