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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 251965  
Subject: A simple bull and bear approach Date: 2/15/2008 11:57 AM
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I love investing, and I love finding the most interesting and optimal
way to do it, then keeping an eye on things every day to see how they go.
However, I do realize that not everyone shares this goal. Sometimes a
pretty simple method to do pretty well is what you really want.

A good way to avoid losing tons of money in the market is to get out
of the market when risks are higher, using some sort of timing system.
This post's approach is a bit different: a long/short hedge.
Don't get scared---this can be pretty simple too.

First, a few words about the stock investment chosen.
Let's assume that your target "long" investment is the US stock market.
I started with monthly total returns of the S&P 500, as tracked by an ETF (SPY).
But, in recent years, I have become a fan of RSP, an ETF which tracks
the S&P Equal Weight index. Same 500 stocks, just weighted equally
rather than by market cap. This performs a whisker better on average
through the years. More recently still, PRF has become available, which
does a whisker better yet, by buying large cap US stocks in proportion to
an estimate of their intrinsic value, rather than their market cap.
For example, if stock A has twice as much in the way of book value,
earnings, assets, and dividends as stock B, buy twice as much of A
as you do B, without regard to the current market cap of A or B.
This avoids buying too much of stuff which is currently overvalued.
In any case, this long process was simply to say I've used the
best currently available broad US equity ETF available at each point.
I simply spliced the more recent RSP onto the SPY series, then replace
that with PRF when it came available. So much for the "long" part.
(remember, everything in this post is calculated on month boundaries only).

For the short part, the obvious thing is to bet against the average,
but that won't do much good since in bad times you'll be market neutral.
Shifting some or all of your money into a market short position is
the same as shifting some of your money into cash. Can we do better?
Early results say "yes". I like the fund BEARX, the Prudent Bear Fund,
which is a US mutual fund (trickier for those of us outside the US
to purchase, but not impossible). I have used it off and on since
September 2000, and have been very happy. It is actively managed,
so, its tracking error versus an inverse index is a bit variable.
To the bright side, they do a LOT better than the negative of the
S&P 500. For example, their trailing 10 year total return has been
+1.94%, versus the S&P's return of +5.14%. Needless to day, +1.94%
is a lot better than -5.14%, which is what a perfect negative-market
fund would have given you. If you look up this fund's price history
for yourself, be sure to include dividends. They get quite a surprising
return from the small number of long postions they hold.

Now, simply holding an optimal mix of this long/short pair does
improve risk adjusted returns a lot, but it isn't going to make you
rich. My tuning gave an optimal mix of 38% short and 62% long.
This gives an annual return of 7.1% a year, which is 1.8% less than
being 100% long all the time. However, it makes a profit in over 94%
of rolling 12-month periods, which ain't what you get with the S&P at 74%.
The worst rolling year goes from -26.4% to -1.9%
The worst drawdown goes from -44.9% to -5.9%
There are those who might like this smooth ride, and be willing to
pay a penalty of 1.8% per year for the privilege.

But, that's pretty boring. Can we do better?

Well, needless to say, it would be nice to be more long in bull markets
and more short in bear markets. Since we are using both long and
short, our timing doesn't have to be very sophisticated at all, since
we aren't fully exposed to the market any of the time.
This is really the key point of this post.

So, for a timing signal, I simply check at the end of each month
whether the current value of my long market fund (after dividends!)
is higher or lower than the average of the last 12 month ends.
This is calculated as the current month end and the 11 prior ones.

Here's the suggested scheme:
Market fund at least 1% above its average: 15% BEARX, 85% long US stocks, no cash.
Market fund less than that: 30% BEARX, 0% long US stocks, 70% cash.
(the extra 1% is a tweak that adds a whisker of performance but isn't necessary)

The "optimal" would actually be even more long and less short based
on the backtest period, but I don't really trust this simple timing
signal enough to be 100% long for this discussion. So, I simply forced
it to have no more than 85% net long (15% short position) at all times.

How well does this work?
In short, about 3% better market returns than buy-and-hold with about 37% of the risk.
I defined risk as a weighted sum of two downside deviations:
one built with an aversion to any negative rolling 3 month period, and
the other with an aversion to any rolling year under 12% return.

So, compared to holding my "long US stocks" proxy, you get the following effects.
(remember, these are imperfect month-end-only calculations)
Annual return goes from 8.89% to 11.95% (+3.06%)
The worst rolling year goes from -26.4% to -2.6%
The worst drawdown goes from -44.9% to -12.6%
Standard deviation of rolling year returns goes from 17.6% to 6.8%
Probability of positive rolling year goes from 73.6% to 95.9%
Risk metric from two downside deviations goes from 39.94% to 14.7%

Now, this relies on the selected timing system being pretty good.
If it isn't, your results will be worse. But, if you don't trust this
timing rule that much, it's easy to do a compromise. Any mix between
the suggested allocation and the "38% short at all times" strategy
is equally valid, and all such blends should improve risk-adjusted returns.

Obviously, relying on the active management of a short-bias mutual fund
is a bit of cheating. But, it has been a decade, and these guys are
pretty good. The fund seems to zoom reliably on sharp market declines,
though admittedly they don't tend to hold onto those gains when the
market rallies. In short, they seem to do their hedging job, and a bit more.

One nice thing about this strategy: though you would have to check the
index against its average once each month, you don't trade often.
This is an 11.4 year test. There were only 5 trades in total.

Jim
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