Parker,
For my personal portfolio I don’t worry too much about volatility if I have lots of confidence in the system. Besides instead of diversifying with one system picking many stocks I prefer three systems with a handful of stocks each.
How do I get confidence in a system? That’s the billion dollar question. By the time you get a long track record it’s often too late. Instead I settle for a short track record that is consistent with the backtest plus factors that are known to work plus a design approach that is know to work.
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What would be really interesting is a 20-30 stock portfolio of highly liquid large caps that could generate 10% of ALPHA per year after launch. My sense is this would require a long term value approach married with a good hedging strategy for times of crazy market volatility.
[/quote]I (and quite a few other designers) could create such a system building on research that we did already. Yet, I don’t expect much demand because the backtest won’t be as pretty as some of the R2Gs and because it will have streaks of under-performance when subs would bail out.
Off the top of my head hedging strategies come in four flavors and each one has advantages and disadvantages. None of them are good enough to fully rely on.
- High quality bonds. This is a tried and proven method. The disadvantage is that it can drag on returns unless you use leverage. Also, there is still a 5% chance or so that bonds go down at the same time as stocks (judging from the past century or so of data) albeit not by a lot.
- Moving average rules. As a value guy, I hate to admit this and it took a lot of data to convince me but these strategies reduce risk during major crashes. It stands to reason. The market doesn’t plummet from 10,000 to 0 in one second; it takes time. This creates a trend that is picked up on. The disadvantage of these strategies is that they can drive people bananas during routine corrections.
- Sector switching. This type of system can work but it is really hard to know how well each individual system will do in the future.
- Economic signals such as plummeting earnings and earnings estimates and rising unemployment. I prefer to use a composite fundamental indicator which will flip the hedge on during a serious economic crisis. The disadvantage is that may miss some smaller corrections and may not turn off the hedge until the market has already recovered somewhat.
- Trend following systems such as CTAs. Very reluctantly I have to concede that the data seems be in favor of this. I don’t know enough about this type of system.
Chaim.