Set Up A Momentum Hedge To Offset False Positives

During his recent conversation with Tobias, Clayton Gardner, co-founder of Titan, discussed Setting Up A Momentum Hedge To Offset False Positives. Here’s an excerpt from the interview:

Tobias Carlisle:
What’s your expectation for the way that the portfolio will perform through a full business cycle? Do you have any view on when is a better time for the portfolio, and when is a worse time for the portfolio? So, for example, if I talk about deep value, deep value does very well, typically at the tail end of a drawdown, and then will do better out of the bottom but tends to lag at the tail end of a bull market because the valued bid just goes away a little bit, so how do you think about that?

Clayton Gardner:
Yeah. It’s a good question. We honestly haven’t thought too much about the relative sizing and weighting of this because we just don’t have other strategies right now. So if I think about our clients, most of their core alternative, a lot of these clients are rolling over accounts from the Schwab or the Vanguards of the world.

Clayton Gardner:
When I see how they’re allocating, most of our clients are coming from a place of diversification. There’s not even really a thoughtful approach to the weighting or any of the value versus growth or small versus large weighting dynamics that you alluded to. Early cycle, late cycle. Most of them, honestly, are just invested across, on average, probably 10 to 15 old school mutual funds paying one to one and half percent so they’re effectively earning under these securities.

Clayton Gardner:
They’re almost just matching the index, doing a little bit worse and paying a high fee to the advisor to do so. So I think first step, as far as get invested, and what we do through the business cycle view this core flagship strategy as a better index by pretty much any means.

Clayton Gardner:
The vast majority of the indexes returns have come from the companies that we own. If you looked at the top 10 drivers of return, probably over the last 20 years, and you looked at our algorithm, how that’s evolved, how the portfolio has evolved over the last 10, 20 years, the vast majority of those largest contributors have been in our composite.

Clayton Gardner:
So the whole point here is that these super stocks that tend to drive most of the returns through the business cycle we’re going to capture with this flagship strategy. Our beta is about 1.15, 1.2, so I think people come in expecting it be a little bit more volatile but so far, keep in mind, this is a hedge strategy too, so this is not just a long only. There is a dynamic hedge component where we-

Tobias Carlisle:
How are you hedging? What’s the trigger for the hedge?

Clayton Gardner:
So it’s a momentum hedge. It’s systematic in nature. What we do is we’re looking at the Titan composite, this flagship strategy composite, so the 20 stock, equal weighted, and we look at that compared to the S&P’s trailing 12-month moving average.

Clayton Gardner:
So at a high level, you could say, “Oh, it’s a simplistic trailing momentum hedge, but the whole point here is, again, it gets back to the behavioral aspect that I mentioned. Most clients’ problem is they fear volatility, or they say they want to be longterm investors, and then they have a drawdown like we’ve had recently and they’ve totally forgotten about their original mandate.

Clayton Gardner:
So the goal here is, when you onboard to Titan, we capture your risk profile. So we’re going to ask you a few questions and we’ll basically put you into either aggressive, moderate, conservative.

Clayton Gardner:
And aggressive users, theoretically they are answering questions and they’re in that bucket because they’re willing to tolerate more volatility so they should be less hedged in any environment. Whereas conservative investors should be more hedged in pretty much all environments.

Clayton Gardner:
And so, the thing about how it works in an environment like this, our momentum hedge triggered at the end of February. So our 12-month moving average versus the S&P’s average performance for the last 12 months, it was crazy because we had significantly out-performed. So the magnitude of a drawdown, and the speed of that drawdown happened so quickly that we turned that hedge on at the end of February. And so far-

Tobias Carlisle:
Is it monthly? Are you looking at it on a monthly basis or are you looking at it on a daily basis? How are-

Clayton Gardner:
Yeah. That’s a good question. We do it monthly. A lot of clients have asked about this. The reason we do it monthly is because, if you look historically, it depends. As your scale gets greater I think you can afford to do this more, but just the number of times the momentum of Titan versus the S&P, the crossover happens, can trigger all sorts of trading consequences.

Clayton Gardner:
Keep in mind. We’re managing separately managed accounts. We also offer fractional shares. So we have our own fractional share trading system, so clients come interesting us, they toss 500, 1000, 10,000 bucks in and they’re equal weighted across stocks like Amazon and Booking Holdings, right? So these are stocks well over $1000.

Clayton Gardner:
So that’s point number one, is we’re investing in fractional shares, and what that means is, obviously the more we trade, the more trades we’re making, so if the hedge is turning on and off every day, which it would, potentially, if we’re evaluating it daily, there’s all sorts of tax consequences and slippage associated with those fractional shares.

Clayton Gardner:
So we’ve found, we back tested this, that monthly, the downside to doing it monthly is obviously is that let’s say we turn the hedge on at the end of February, all of a sudden this coronavirus thing was a complete one-time event, blue skies emerge, and a week later into mid-March, everything has gone back to normal.

Clayton Gardner:
Getting stuck with a one month hedge, we’re basically short beta in a potentially vicious rally eats into returns. So that’s the cost of doing it monthly. But the benefit-

Tobias Carlisle:
The whipsaw.

Clayton Gardner:
The whipsaw. But the benefit, obviously, and we call those the false-

Tobias Carlisle:
The false positive.

Clayton Gardner:
False positives, exactly. So we back tested it and generally speaking, the way to think about it is the number of times where there’s a false positive, the hedge turns on and you actually cost our clients money. In the real deal events, where the hedge is actually on for a number of months, which I personally, it’s not investment advice, but I personally suspect it will be, if our thoughts on how this situation will play out, the magnitude of the volatility and the drawdown foregone that our clients have by having that hedge on offsets all the times that the false positive costs them.

Clayton Gardner:
So it’s a monthly hedge. It’s systematic in nature. We’re very unemotional about it and the day it turns, it turns. And the goal there, again, is it does, through the cycle, it does eat into compounded returns a bit, so whether you’re aggressive, moderate or conservative, you come to Titan, having the hedge in place at Titan will eat into a bit of your compounded returns, but it does improve Sharpe pretty meaningfully.

Clayton Gardner:
So the volatility, even this year to date, and it actually has improved year to date returns as well, so we have outperformed the S&P, which is surprising given our higher beta, but across risk profiles this year as a result of having that hedge on.

Clayton Gardner:
So it’s something that it is personalized, so that’s why, again, we’re not a mutual fund or a ticker. Some clients ask us, “I would love to own Titan in my E-trade account, or my Vanguard account.” We tell them, “We wouldn’t be able to personalize this hedge if we didn’t know who you were. We wouldn’t be able to know who you were if we didn’t have this direct to consumer platform.

Tobias Carlisle:
It’s been a very rough time for trend following because it’s been a period where there have been lots of whipsaws, and so it’s lag, which is what happens at the end of a bull market. You get the false positives where it gets switched on and the market runs away, but the reason to have it is for exactly the thing that we’re going through now. It should chop off that max DD, max drawdown, should be much, much lower or better than it would otherwise be without it.

Tobias Carlisle:
And I think anybody who has been through a 2007, 2009 or a 2000, 2002 sees the value of it. Folks probably who got whipsawed in 2018 probably don’t, but I think it’s a good approach. I think it should work. I’d be interested to see how you guys go with it.

Clayton Gardner:
No, that’s funny because we actually did activate that hedge, it was January 1st of 2019. So you can imagine what clients were saying because we finished Jan ’19, I think it was up something like mid-teens, and the market too was up 13% on the S&P. So January was, it just rallied.

Tobias Carlisle:
Went up a little bit.

Clayton Gardner:
The hedge quote/unquote ripped our faces off, and so we definitely got an earful from clients. It was a good learning experience, right? And they’re getting educated just as we are as we’re doing live trading. We’ve tested all this stuff on a back tested basis, but you don’t really get to understand the clients’ pain points and how they think about it until you’re live, and yeah.

Clayton Gardner:
I think, like you said, it’s just a batting average, or I should say, slugging average thing. If we can be right, in terms of real deal events versus false positives 51% of the time, like you said, just the magnitude of the drawdown that we’ll be able to save, I think will make it worthwhile.

Tobias Carlisle:
The toughest thing is when you test it and you’re testing it on a monthly basis or something like that, when you’re two weeks into it and you feel like you should have it on, or the first time that it crosses through and you want to put it on.

Clayton Gardner:
Yeah.

Tobias Carlisle:
I think that’s the hardest thing about using the moving average.

Clayton Gardner:
Totally.

You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:

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