The Day After

At this point it looks like the market is shaping up for a sideways day after the rebound in Shanghai overnight and smaller losses in European trading than Wall Street experienced yesterday. I put on a hedge trade - long 2 ES and short 2 NQ which is biased to the long side, but exited it at a loss as I had a meeting at 9:30 and it didn't seem to be doing well. It would have been in the money by now. So I guess I am just jittery after yesterday though I made plenty of money in the US market, but got slammed of course in Australia. I don't know the full extent of damage there as mutual fund prices are reported with a delay. Worst are probably the losses in resource stocks affecting my CFS Global Resources Fund which has about 10% in each of RIO, BHP, and RTP (those are the US tickers). The more hedge fund like instruments mostly responded better, though EBI.AX fell 5% and hedge fund manager EBB.AX fell 8%. I reckon I was probably slightly up yesterday overall, though I don't know how the short-term Australian Bonds in the CFS Conservative Fund (my biggest holding) responded. The Aussie Dollar fell and US bonds rose.

But I'm not worried that I don't have a trade on. I don't have to have a trading position at all times. I used to think of my short-trades as hedging my long positions and felt nervous if I didn't have a short when I thought the stock market might fall. But now I think in a much more "alpha-centric" way. Alpha are returns that are not correlated with stock market returns while beta reflects returns that are correlated with the market. I divide my portfolio into three sections:

1. Hedge fund type instruments that hopefully generate alpha. Sometimes some of these seem to have a bit more beta than I was reckoning on.

2. Beta - mainly long-only mutual funds whose return is mostly correlated with market returns and may have a positive alpha. It's no big deal if their alpha is negative to a small degree (one reason I am not worried about expense ratios which tend to reduce alpha) because I can generate alpha elsewhere in my portfolio. I change my exposure to these funds over the 4 year stock cycle. At the beginning of the cycle my exposure to stocks would be much bigger. I don't have to get my market timing perfectly right. At the moment I am 50-50 in bonds and stocks reflecting the late stage of the cycle which maybe now is heading towards the bottom - assuming that we need to see a 20% correction before the cycle is over. At the beginning of the cycle I will use leveraged stock funds and margin.

3. Short-term trading - I regard this now also as a generator of alpha. The trades are in ETFs or futures and so have a +1 or -1 correlation to the market while the trades are on. But the stochastic model has a zero beta coefficient to the NASDAQ 100 index. So in the long-run the returns are all pure alpha.

And of course I am also diversifed across US and Australian Dollars.

I've arrived at this strategy after a lot of experience and seeing what works and what does not and what I can tolerate emotionally. It's much more sophisticated than the standard "buy and hold" long-only models. I know I can't tolerate the fluctuations that that leads to. It was interesting seeing the responses of some newbie investors yesterday to the drop in the markets - which in the Dow was significant for a one day drop but was really not that much of a decline off the highs yet. I wonder how many will throw the towel in when we are down 20%? I started investing and trading in 1997 and have been through the high volatility of the 1998-2002 period. I also remember very well the crash in 1987 though I wasn't invested (I did buy a little in some Israeli mutual funds before then and was an undergrad economics and geography student) and even dim memories of the 1970s. Even then I was interested in investing and would discuss things occasionally with my father who was a long-time stock and mutual fund investor though he certainly wasn't wealthy then (we were definitely lower middle class in Britain) and read the financial news.

Anyway, here is what happened in one account, my account with Interactive Brokers:



You can see the big dip a couple of weeks back and then yesterday's recovery, followed by more erratic trading. My Ameritrade account would have a similar pattern. My z-score in NQ trading (total of 209 contracts traded) is now 2.03, which means that the probability that my performance is random or actually negative is something around 2%. The Kelly ratios though for both this and my weekly results in my IB account say that I should be taking on huge amounts of leverage. The Sharpe ratio for the weekly returns on my IB account is 1.68, which is a respectable number for a hedge fund.