How asset price affects your alpha

Discussion in 'Options' started by TheBigShort, Feb 3, 2019.

  1. ironchef


    Thank you for taking the time to explain in BAB, one trades long/short.

    On second thought, looking at your example, in an up trending market levered SPY outperforms BAB SPY in almost all aspects of measurements.

    Isn't that similar to what I said: a simple BWB is better than BAB?
    #11     Feb 5, 2019
  2. srinir


    No. If your assumption was correct SPHB would have outperformed lower beta (in this case SPY).
    Probably following is the better example. SPHB has the beta of 1.3. Choose lower beta etf of SPLV. It has beta of 0.65. Both screens from the same stock universe.

    I will go short SPHB (bet against beta) and long lower beta (in this case SPLV). You cannot just go long-short in dollar notional way. It has to be in beta-notional way or vega-notional way. From both respects, we have to go long twice the SPHB notional.

    Here are the results. Shorting high beta and going long low beta had almost similar results as going long SPY with zero market correlation
    #12     Feb 5, 2019
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  3. ironchef


    Another question on SPHB vs SPY:

    It just does not seem right to me. If I trade levered SPY: either buying a combination of SPY+SPY call options or buying xSPY with borrowed money (x>1), my return should be higher than SPY net of the cost (premium or borrowing) in the time period you showed. Could it be an artifact of how SPHB is constructed?
    #13     Feb 6, 2019
  4. This is not what srinir or the article is pointing out. High Beta stocks underperform leveraged low beta stocks. By constructing a portfolio of short high beta stocks and leveraged long low beta stocks you get a decent return while "removing" market risk.

    Of course you would have out performed the market if you were leveraged SPY from 2012 to 2018 but you opened your self up to alot of market risk which is not desirable.
    #14     Feb 6, 2019
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  5. srinir


    SPHB construction is fine.

    From their website " The Invesco S&P 500® High Beta ETF (Fund) is based on the S&P 500® High Beta Index (Index). The Fund will invest at least 90% of its total assets in the securities that comprise the Index. The Index is compiled, maintained and calculated by Standard & Poor's and consists of the 100 stocks from the S&P 500® Index with the highest sensitivity to market movements, or beta, over the past 12 months. Beta is a measure of relative risk and is the rate of change of a security's price. The Fund and the Index are rebalanced and reconstituted quarterly in February, May, August and November."

    If i were to form market neutral fund, that's how i construct the fund. Short top 20% and go long bottom 20% in beta notional or vega-notional equivalent.
    Last edited: Feb 6, 2019
    #15     Feb 6, 2019
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  6. ironchef


    Thank you.

    Is there any simple way to explain why the performance lagged SPY?
    #16     Feb 6, 2019
  7. srinir


    It was explained in the article. Here is the direct link to their paper.

    "A basic premise of the capital asset pricing model (CAPM) is that all agents invest in the portfolio with the highest expected excess return per unit of risk (Sharpe ratio) and leverage or de-leverage this portfolio to suit their risk preferences. However, many investors, such as individuals, pension funds, and mutual funds, are constrained in the leverage that they can take, and they therefore overweight risky securities instead of using leverage. For instance, many mutual fund families offer balanced funds in which the “normal” fund may invest around 40% in long-term bonds and 60% in stocks, whereas the “aggressive” fund invests 10% in bonds and 90% in stocks. If the “normal” fund is efficient, then an investor could leverage it and achieve a better trade-off between risk and expected return than the aggressive portfolio with a large tilt toward stocks. The demand for exchange-traded funds (ETFs) with embedded leverage provides further evidence that many investors cannot use leverage directly. This behavior of tilting toward high-beta assets suggests that risky high-beta assets require lower riskadjusted returns than low-beta assets, which require leverage."
    #17     Feb 6, 2019
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  8. ironchef


    I think I understand it now. Thank you for taking the time to explain. I trade leverage equity using options but since 2018 it is getting riskier and much harder to be profitable:


    1. If long/short SPHB and SPLB is "market- SPY" neutral, then why the STDEV similar (correlated to, from eyeballed the return curve) to SPY's?

    2. What if I construct a SPY neutral position using a combination of options and underlying mimic long/short SPHB/SPLB?
    #18     Feb 6, 2019
  9. ironchef


    So, does that means higher beta assets (like if I levered SPY) have lower risk adjusted returns even though in a bull market I get higher absolute returns?

    The abstract is the only part of this paper that is comprehensible to me. The body is simply too hard to understand, especially for one not familiar with the terminologies. I need to go back to school to learn some finance.
    #19     Feb 6, 2019
  10. You can always hedge your SPY long with a portfolio of short SPHB and unleveraged long SPLB. That way you have a negative 1.0 beta hedge on on your positive 1.0 beta SPY with a significantly positive expectation (hedges normally have zero or slightly negative expectation -- i.e. it costs money for insurance), Also your hedge is probably, since low beta tend to have higher dividend yields, that rare thing: retail-self-financing (zero-weight). So you'd be protected on the downside, your hedge wouldn't cost anything to carry, and it would even make you money (like having your car-insurance company send you a monthly check instead of you paying them).

    N.B. I haven't actually run the numbers on this, so caveat emptor. It's based on something low-beta proselytizer Eric Falkenstein published years ago, before he went off the rails.
    #20     Feb 6, 2019
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