Memo to: Vega Capital clients
From: Scott Shuttleworth
Subject: Profiting from downside risk
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Earlier this week we reported our performance for the quarter (+5.7 per cent). We also broke this number down into returns from our active risk positions (+14 per cent) and our hedging book (-8.3 per cent).
Naturally, investors may wonder why hedging is required when it’s clearly so costly. After all, if we didn’t hedge, we could deliver much higher returns. But this is only true if nothing goes wrong. The benefit of hedging occurs when things do go wrong.
So today we’re going to run some simulations to see the benefit of Vega’s hedging algorithm.
Let’s run the Vega strategy on some historical data using just SPY puts with a duration of 12 to 18 months. We’re firstly not going to hedge in order to see how volatile the portfolio’s performance gets and emphasise the value of hedging.
The period we’re going to test over is the first half of FY11. Over this period, the US lost its AAA credit rating which caused a minor panic in the markets.
To start, here’s how the index did over that period.
As above, the SPY declined by 6.3 per cent. At its worst it was down 18.8 per cent. Annualised volatility was 30 per cent – clearly a rough patch.
Vega’s portfolio at this time would have been long market exposure due to the strengthening economy and expensive put option prices. Clearly with the index falling from 135 to 110, a portfolio of written puts is going to fare quite badly but this is what Vega would have had.
So let’s look at how Vega performed without the hedging algorithm.
In short – not well. The strategy lost 6.1 per cent for the half, what was worse however was the > 40 per cent drawdown incurred. Annualised volatility for the period was a gut wrenching 77 per cent. Quite clearly, this is not an experience we would hope to incur in the Vega portfolio.
The index lost 6.3 per cent so technically the strategy outperformed. However at Vega we don’t consider a negative return as outperformance – even if it beats the index.
Now let’s add back in the hedging algorithm and see how Vega performs.
What a difference! By using the hedging book, the strategy is able to hold on during the market collapse and then also capture the upside from the recovery. There’s still a draw-down of 16.4 per cent and elevated volatility of 43 per cent (annualised) however Vega returned 21.7 per cent over the period – outperforming by 28 per cent.
The value of hedging is hence very apparent. Vega can generate strong returns in bull markets even if hedging is expensive and this is a good trade off to ensure it can generate returns in weaker markets.
The Vega Fund has now formally launched and is open to sophisticated and wholesale investors. Qualified investors may find our Information Memorandum and Application Form here however if you would like a hard copy mailed to you, please don’t hesitate to contact our office on 1800 960 707.