Subject: Re: best way to hedge an SPY portfolio
Actually, Jim's results. I was just reposting from the old board...

The problem with any dynamic hedging is that it is almost completely reliant on the predictive power of the market timing signal used. Most signals simply don't work after they have been invented and tuned, so most dynamic hedging strategies are bad.

My old post was no different--it made a lot of sense on the surface, but it's still bad if the timing signals it uses are bad. The timing signals suggested haven't been good. Into the same category might fall the fat that the equal weight S&P 500 beats the cap-weight S&P 500 in most multi-year stretches, but certainly not all of them, and certainly not lately.

The scheme had a second, much more subtle problem, which is a sneaky trap for a lot of hedged strategies--as with any hedged strategy, at any given time one side is making money and the other is losing. This is fine if the only thing you care about is the sum of the two values (which should be the case or you drive yourself crazy), but the problem is if one of them is making money on a mark-to-market basis only, while the other is losing money on a cash basis. In the scheme proposed, that is generally the case in rising markets: your RSP is rising in price but you're not selling it, while short futures contracts suck cold hard cash out of your account moment by moment. Even though your portfolio balance is doing fine, you would periodically have to sell bits of your "hold forever" long position to wipe out the negative cash balances it would create.

I have become much fonder of simpler solutions: if the forward return prospects of something you own, over the next couple of years, are not good, then sell some and raise cash. Unfortunately you can sit on cash for long periods, so the flipside is you have to be prepared to really pounce seriously when there are good deals available during a nice panicky crash. This is of little use to most investors as most investors don't have a clue what a given security is actually worth. It has taken me many years of study to reach the point of realizing that I'm mostly in that category too. Maybe only mostly in that category if I'm being vain?

To the extent that you are able to value a few things, you can at least try to avoid holding them when their valuation levels are too high to make sense. e.g., everybody loves Costco as a business and as a stock, and it deserves a premium, but I wouldn't hold it at these valuation levels (58 times trailing earnings) because if it merely returned to its own historically normal but lofty valuation levels (say, 26-31 times earnings) it would be a pretty big drop. Most things can't be valued this trivially, but it's an illustration.

Jim