XTR – Market Neutral

It might look strange, but though the problems are more in America, it’s the Romanian markets that feel the heat. One of the reasons emerging markets like Romania are more volatile is because markets lack the knowledge of risk management. We are ideally speaking still a “LONG ONLY” market. We don’t have mechanisms to short sell, we don’t have many representative benchmarks, no index futures for hedging and just a few stock futures with some trading volume. No wonder emotional content is high owing to lack of hedging instruments. And the only executable strategy when markets fall is to ‘SELL’. This is the reason we want to dedicate some time to risk management. As a good risk management strategy can avoid unwarranted panic.
Market neutralizing of a portfolio can be done using many techniques. We can use market sensitivity indicator beta (XTR.100308), inter market and sectoral correlations and annualized interest rates in the futures market. Just like beta correlations can be used for stock selection. Stock pickers can avoid high beta in euphoric times and select the same stocks in a panic (as the same stocks fall the most and relatively become the most inexpensive) or use negative beta sectors and stocks to bring the overall portfolio beta (sensitivity) down (like we did for XTR 21). Or one can just select stocks with beta at 1 to create a portfolio that just simulates the market.
High and low correlations make stock selection a bit more easy. For example all of the BETFI components (SIFs) have near 1 betas, which makes stock selection easier for anyone wanting to take exposures to BETFI components (he can use any of the SIFs to capture the BETFI growth). The similar analogy can be extended to other sectors of the local equity universe. This is what we have tried to illustrate using sector based correlation matrices. We will be delving into correlation in more detail next issue when we will illustrate the meaning of high and low correlations and how market pairs can be identified using correlation matrices. What is the link of correlation with risk? And how can management of risk mean a profit when you execute a pair trading (market neutral) strategy? Understanding correlations can not only allow the fund manager to neutralize unwanted risk but also create relative alpha despite market negativity.
This issue builds on where we left last time with stock betas. In slide 4 we create two portfolios of different weights and beta and then we use SIF 2 and SIF 5 Futures to hedge the same portfolios. So we are using futures to hedge any portfolio made of various stocks. We can even use SIF Futures to hedge a portfolio without SIFs. Strange as it may sound, statistical hedging is mathematical and sound. Statistical hedging also highlights why thumb rule hedging may not work in markets and can be bad risk management. A simple example are SIF futures. Though conventionally believed that SIF futures are more volatile compared to SIF spot, the reality is opposite. Spot SIFs are more volatile than their respective futures and hence have a lower beta compared to spot SIF components. And this is why SHORTING 10 (10*1000 units) contracts of SIF 2 FUTURES against 10,000 units of SIF 2 spot is far from a perfect hedge and can lose money. We have illustrated the Hedge sheet on slide 4 and 5. How SIF 2 and SIF 5 futures used along and together can be used to hedge the underlying portfolio.
On the XTR 21 front, we had another week of XTR homogeneity compared to the market. It found its place yet again between the market indices. This makes it a good benchmark as it does not spike up or down compared to the overall market. XTR seems very selective about volatility. It captures the positive volatility (upsides) and shuns the negative volatilities (downsides). A model with a less drawdown is always preferred to one with a high drawdown, like BETFI this week, which fell the most out of BET, BETC and XTR 21. This high BETFI beta caused the first divergence in more than six weeks between XTR and BETFI (slide 7). Sectorally too this was another interesting week as energy outperformed all the other sectors. Energy is a late expansion sector and should continue to outperform along with materials followed by staples and utilities.
To read the latest issue of XTR.170308, write to us for a free trial today or download the report from REUTERS KNOWLEDGE, YAHOO FINANCE, THOMPSON ONE or THOMPSON RESEARCH.