seeking value with active risk management

In most areas, investors expect to use a mix of passive exposures for capturing a market’s return and active strategies for the possibility of outperformance. Curiously however, today’s “hedged equity” offerings remain almost exclusively passive with most strategies using static options exposure to manage passive investments in indexes like the S&P 500.

Though there are many variations, these strategies broadly track two markets: stocks and defensive options (e.g., puts). While this combination has consistently reduced volatility, constant exposure to the declining trend of defensive options creates a strong tendency for the typical “hedged equity” strategy to underperform the market over time (chart).

*Cumulative Performance Relative to S&P 500 TR Nov 2016 - Aug 2024. Source: barchart.com. Click for larger image*

To address this issue, TCM went back to the drawing board and designed a new risk management approach that is among the first to seek long term profit from defensive positions by:

Using a tactical hedging strategy

To avoid the negative trend of continuous hedging, TCM’s risk management process deploys hedges only when crisis conditions are present (generally, upon inversion in the VIX futures curve) seeking to protect portfolios from crisis periods while allowing for full exposure during more favorable environments. Unlike passive strategies, this active approach can both realize crisis hedge profits and cut “near crisis” hedge losses in its effort to create and preserve long term hedging gains- a previously foreign concept in the hedged equity space.

Focusing on VIX exposures rather than options when hedging

Since they respond mainly to implied volatility rather than the complex mix of option variables, VIX exposures can often be more effective than options for hedging equities during the sharply rising implied volatility common to crisis periods.

new philosophy, new results

Since it was first put into production with the launch of Tactical Beta in October 2016, this pioneering risk management strategy has plainly stood apart from its peers, outperforming traditional hedged equity strategies partly through crisis hedge gains but also by limiting non-crisis hedge losses (chart).

*Cumulative performance relative to S&P 500 TR, 11/1/2016 - 8/31/2024. Source: barchart.com, TCM. Click for larger image*

Though cost/benefit analysis is considered common sense in most other areas, it seems to have been abandoned with static hedging approaches that focus on limiting declines to the exclusion of all other factors, including an investor’s total return. With a simple refinement to this risk management philosophy nearly eight years ago, since inception Tactical Beta has:

Significantly outperformed its peers in rising markets, with 76% “up capture” since inception as of August 2024 versus 44% for the Hedged Equity Peer Composite*.
Proven more effective during crisis periods like Feb 2018 (Tactical Beta +8.6%, HE Peers* -2.5%) and Mar 2020 (Tactical Beta +19.5%, HE Peers* -4.3%).
Beaten the S&P 500 and produced over 3x the cumulative return of its peers, with a total return since inception of 227% for Tactical Beta versus 205% for the S&P 500 and 72% for its Hedged Equity Peers* as of August 2024 (chart).
*Equal weighted composite of JP Morgan Hedged Equity (JHEQX), Swan Defined Risk (SDRIX) and Gateway Fund Cl A (GATEX), rebalanced monthly.

*Growth of $1000, Nov 2016 - Aug 2024. Source: TCM, barchart.com. Click for larger image*

Of course, a unique strategy will naturally produce unique tradeoffs.

First, to pursue its goal of long term hedge profit, TCM’s active risk management was designed to differ from the negatively-trending “benchmark” of continuous option exposure used by most other strategies. Since inception, this novel approach has indeed taken a different path, achieving its goal since inception even while trailing the market or its peers in many scenarios - a result only possible if the strategy’s overall benefits have outweighed its cost. (See comparison of monthly capture ranges below)

*Monthly capture ranges since inception, S&P 500 months greater than +1% or less than -1%, Nov 2016 - Aug 2024. Source: TCM, barchart.com. Click for larger image*

Second, tactical VIX hedging is not well-suited for rare low-volatility declines when a wider set of inputs can favor options over volatility-only exposures like the VIX. In 2022, this scenario saw passively hedged peers* outperform Tactical Beta for the first time in any calendar year since inception- a brief advantage that has since been eroded by the persistent drag of passive hedging.

Finally, active risk management has no pre-determined index level "floors" like some option-based strategies and due to its tactical nature, is not well-suited for protecting against truly unanticipated market shocks.

hedging your hedges

With the arrival of active risk management, investors can now diversify their hedged equity allocations more fully, with greater flexibility to construct an acceptable balance of risk reduction and potential for outperformance. For example, since Nov 2016 a 50/50 blend of Tactical Beta and traditional hedged equity strategies* achieved a higher Sharpe ratio than the S&P 500, producing 1.6x the annual return of the passively-hedged peer group* while still maintaining 35% lower volatility than the S&P 500.

Just one of many variations, this concept may be useful for investors seeking to optimize their hedged equity allocations by incorporating an active strategy. As one of the few strategies applying risk management (active or otherwise) to the Nasdaq 100 index, TCM’s Tactical Q could play an especially attractive role in this project.

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*Equal weighted composite of JP Morgan Hedged Equity (JHEQX), Swan Defined Risk (SDRIX) and Gateway Fund Cl A (GATEX), rebalanced monthly.