How to Gain a Hedged Trading Edge

For now, we can rest somewhat easy that the stock market has whistled through the graveyard and emerged into the sunshine.

This allows us to get back to our discussion of hedge funds that we started several weeks ago but had to postpone.

A couple of weeks ago, we talked about how the California Public Employee Retirement System (Calpers) decided to quit investing in hedge funds.

Many in the media have proclaimed the death of hedge funds. As we discussed, this is far from the case, but there are problems in the traditional hedge-fund business model that need to be addressed.

The thing is, hedge funds impact stock prices much more than they have in the past. That’s because “hedgies” are such active traders that they can move markets quickly and sometimes in a big way.

By contrast, mutual fund managers and traditional managers for the most part adopt much more of a buy-and-hold strategy and trade less.

My thinking is that, by understanding how hedge fund managers operate, we can better take advantage of their inefficiencies.

Why Hedge Funds Work

First, let’s define a hedge fund. It’s a fund that is both long and short stocks — and/or other asset classes like bonds or commodities.

Its goal is to reduce the exposure of only owning stocks by shorting stocks.

Most mutual funds only buy stocks. So, when the market is moving higher, a mutual fund that is 100% invested generally gets rewarded with almost a 100% gain of the major equity indexes like the S&P 500.

That’s the good news for mutual funds and the investors who have money in them.

The bad news is that, when markets correct, a mutual fund will probably lose as much as the S&P 500 — or more, depending on the stock-selection process used.

Meanwhile in an up market, a hedge fund may not make 100% of the gain of the index … but it also won’t lose as much when the market corrects.

The hedge fund’s goal over time is to generate 1%-2% in gains, month after month. That is easier said than done, and this year validates that statement.

Hedge Funds’ Secrets to Trading Success

Hedge funds can move from net long (greater long exposure minus short exposure) to net short (greater short exposure minus long exposure) if the fund believes that the market is overvalued.

There are several variations on this style.

• The first is long/short, as described above.
• The second is market-neutral long/short. This means the fund is always long the same amount the fund is short. The goal here is that stock picking works leading to consistent gains.
• The third is a macro hedge fund. A macro hedge fund drives its stock selection on its economic outlook.

Let’s look at how these styles have fared this year …

The S&P 500 was up 7.25% year-to-date through Wednesday’s close. Meanwhile, the Russell 2000 was down 1.48%.

The average long/short fund is up 3.22% through the end of September. Market-neutral is down -1.52% and global macro is down 2.63%.

The best hedge return has come from managed futures, which have returned 6.37%. The conclusion is that hedge funds as an asset class are lagging the market.

Why Aren’t Hedge Funds 
Rolling in Profits Right Now?

The lag is due to just more than the volatility seen in the second half of the year. Much of it has to do with the parameters set on how they can invest.

Many long/short managers have to have an equal beta on the long and short side. Beta is defined as risk.

A beta of 1 would have the same risk as the S&P 500. If that index fell 5%, then a stock with a beta of 1 would drop 5%.

This leads to a potential problem where the long and short always cancel each other out.

A better approach would be to have a higher beta on the long side when the market is rising and a lower beta on the short side. This would enable the hedge to produce better returns.

Conversely, in a market that is falling, the beta on the short side would be higher and the beta on the long side would be lower.

TSLA, PG: A Hedged Edge

A great analogy would be to be shorta high-beta stock like Tesla (TSLA) when the market is falling and be long a low-beta name like Procter & Gamble (PG).

In the chart below you can see that this pairing worked well as a hedge during the drop in September into mid-October. This hedge made 19.41% as it rose in value from a starting price of $0.31 to an ending price of $0.37.

The takeaway here is to not pair stocks with the same beta (i.e., both long or both short).

Another issue that hedge fund managers run into is confirmation bias. We will aim to pick up that topic next week. In the meantime, let’s review our thinking on a few ideas we have been tracking in our weekly column.

A big plus is that the S&P 500 has moved above its 200-day moving average and all other key moving averages.

However, the Russell 2000 and the iShares Russell 2000 (IWM) are still below their 200-day moving averages as well as key retracement levels from the August low to September high and the May low to July high.

The conclusion we remain with is we would love to be bullish here, but the models tell us this move still has the potential to be a head fake and that some type of retest in the offing.

However, the worst case for the Russell 2000, which was IWM retesting the May low at $107.44, may have played out. I noted that I remained neutral on this small-cap index and would turn positive if IWM overtakes the 61.80% retracement at $112.61.

It has done that … and then some.

The key for many stocks going forward continues to be the greenback. But with the recent trading action, the U.S. dollar is not a problem for the stock market … or for some of the trades we’ve been following together.

As such, we are done tracking the U.S. dollar for now and will alert you if it becomes a problem down the road.

We also remain with a recommendation on United Parcel Service (UPS). The cost basis is $97.25. The stock is at $102.30, as of Wednesday night’s close, so we are up on the trade nicely after some but not a great deal of angst.

Stay long the stock — the economy is in good shape, which means business is good for the delivery business.

Our last open buy idea is gold via SPDR Gold Shares (GLD), which I introduced this summer at $126.53 this summer. GLD is lower now at $117.61.Gold is stuck in a range here of $114 to $126 but as we’ve been discussing, a breakout may be forthcoming.

GLD has now almost completely retraced its entire move from Dec. 31, 2013. The dollar remains key to gold and GLD.

Bottom line: In this market, it makes sense to remain patient. And when you do trade, continue to just nibble for now.

Cheers and Hit ’Em Straight,
Geoff Garbacz

P.S. Six years ago, my colleagues James DiGeorgia, Dan Hassey and I teamed up to create the ultimate stock trading system. And simply put, the results we’ve been able to achieve have been pretty amazing.

In that time, my Morning Matters stock portfolio posted a 72% win-rate, and over 840% in gains … crushing the S&P 500 many times over!

….more:

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