Frequently Asked Questions

1. What do you mean by a combination of professionally managed, complimentary ETF securities?

The Active Hedge Overlay (“Active Hedge”) uses proprietary trend following signals that are monitored by our team to signal when to put on long or inverse positions.  The ETF securities used to execute the signals compliment the client’s existing portfolio as they appreciate along side the client holdings in up markets and attempt to protect the client holdings from losses in down markets.

2. How does the Active Hedge protect portfolios in down markets?

When an inverse, or “sell” signal is given on either of our equity models, inverse ETFs are purchased which appreciate as the market declines, generating profit to offset losses in the client portfolio.  When an inverse, or “sell” signal is given on the fixed income model, the fixed income positions are liquidated and we move to cash or cash equivalents until a new “buy” signal is given.

3. Why does the Active Hedge lag market or benchmark performance at market turns?

Since this is a trend following model, the indicators on the equity portion can take as long as 2 weeks to get into position to give a new signal after the market has turned.  Sharp, climactic reversals tend to cause the most lag.  So while the client portfolio is protected on the way down, some of the profits generated by the Active Hedge are given back before the Active Hedge detects a change in trend.  When the Active Hedge is late turning higher on a ‘buy’ signal, the average period of time to catch up to the benchmark return is typically around 60 days. 

This lag in the indicators finding and locking onto the next new trend also occurs with the fixed income model, however, this model tends to be slower moving and much more forgiving.

4. What are the signals used by the Active Hedge?

The Active Hedge uses a mix of proprietary signals that measure the strength of the equity and bond markets over different time periods.  We have an intermediate term equity signal which examines a three month time period, a short term equity signal which uses a one month time period, and a long term bond signal, which uses a 9 month time period.

The reason for three separate signals is for balance.  Any quantitative trading system will give false signals occasionally, but with three separate signals measuring three different time periods, the effect of bad signals is reduced.  The true power of this system is when all three signals detect a trend and the Active Hedge participates in that trend.

The annualized returns for the 12 year period 1997 – 2008 are as follows:

With returns like these, the first question we are asked is why we don’t run this strategy on its own to generate these types of returns?  The reason we don’t is because the volatility and draw downs on this system on its own are both very high (see above table).  When it is paired with a static, long only portfolio, the volatility drops sharply due to its pairing with a more stable, consistent portfolio.

5. How do you adjust the Active Hedge to fit client accounts?

The Active Hedge is applied on a beta adjusted basis.  The client shows us their existing portfolios and we compute the portfolio beta vs. the S&P 500 as a standard benchmark.  Depending on how much of the portfolio the client wants to hedge, we adjust the volatility in the Active Hedge by increasing or reducing the bond position.  The higher the volatility in the Active Hedge, the lower the dollar amount the client has to commit to hedge.

The following example illustrates the process:

Client A has a $10 million portfolio which has a beta of .90 as compared to the S&P 500.   Client A wants to hedge 75% of the portfolio. We then compute the amount needed to give the client the desired 75% hedge based on the beta of the Active Hedge which can be higher or lower depending on how much volatility the client is comfortable with.

The formula for computing the amount needed to hedge is:  (“Client A” Portfolio Beta / (Active Hedge Beta * Leverage)) * Hedge Percentage * Portfolio Amount.

For example, if the Active Hedge is set to a beta of .90, $750,000 would be required to hedge the $1 million portfolio with the same beta.  The computation is as follows: (.90 / (.90 * 1)) * .75 * $1,000,000 = $750,000    If the Active Hedge is set to a beta of 1.1 by adjusting the equity/bond mix, the amount required to hedge would be .9/1.1 * $1,000,000, which equals $613,636.

The computation is as follows: (.9 / (1.1 * 1)) * .75 * $1,000,000 = $613,636

If two times leverage were used, the amount needed to hedge using a 1.1 beta for the Active Hedge would be $306,818.  If leverage is used, however, the client must be able to withstand wider swings in the active hedge. The computation is as follows:  (.9 / (1.1 * 2)) * .75 * $1,000,000 = $306,318

6. How can false signals be avoided?

In an automated system such as the Active Hedge, false trend following signals are sometimes generated.  Our three signal system acts to diminish the effects of false signals in the model as all three signals are measuring different time periods.  We also have limited discretion to reduce position size if we believe a false signal has been generated.  While we never ignore any signals generated, we reserve the right to reduce position sizes on long signals that we believe may be unreliable.  Signals to go short or inverse are never reduced as downside protection for the client portfolio is the very reason for the existence of the Active Hedge.

7. In what periods does the strategy work best, and during what periods does it not work as well?

This strategy works best in trending markets which allow the individual pieces to ride their respective trends either up or down.  Very volatile, wide swinging, or choppy markets reduce the effectiveness of the signals.

Since this system is a trend following system, it tends to lag at market turning points, or hinder returns in volatile, choppy markets, similar to what occurred in the first quarter of 2009.  The returns for the first four months of 2009 illustrate this point:

*Assumes a 61% hedge of the underlying Russell 3000 Benchmark Index.

8. Why doesn’t your presentation show return streams from the stand alone Active Hedge?

As mentioned above, the Active Hedge on its own is very volatile.  Its pairing with a stable portfolio reduces equity swings and volatility due to the time periods where the Active Hedge is inverse (short) and the client portfolio remains long.  The Active Hedge and client portfolio tend to offset each other as the Active Hedge is protecting the client portfolio from downside risk.  Since the Active Hedge will never be offered to clients on its own, the only meaningful returns are those generated by pairing the Active Hedge with client portfolios or their appropriate benchmarks.

9. How much money do you run in the Active Hedge currently?  Why was it developed?

The Active Hedge is brand new and is just being introduced.  It has undergone several modifications during the development process to attempt to reduce overall volatility.  The product was developed because we saw a need to help clients protect their assets without having to liquidate existing equity portfolio positions and realize potential tax consequences.  This allows clients to continue holding equity positions that they feel good about while reducing the market risk associated with holding those positions.