Tuesday, August 16, 2011

Alpha Trades and Beta Trades

Rick Vollaro has introduced the investment team to a new term, “trading with a hatchet.” You can find his blog on the subject in this space (posted yesterday). I can assure you that we don’t let Rick get near anyone in volatile markets with a hatchet, especially when the markets are going in the wrong direction. However, his point was a good one. For the past month or so we have been gradually and incrementally changing the construction of our managed accounts to reflect our view of deteriorating economic fundamentals. When we do inter-sector trades, or sector rotation trades, we call them “alpha trades,” meaning they can impact our ability to outperform our benchmark on a risk-adjusted basis (positive alpha), but they are not necessarily going to have a major impact on portfolio volatility. Over the past month our scalpel trades, or alpha trades, included rotating from Equal-Weight Industrials to Aerospace & Defense in the industrials sector, from Managed Care to Pharmaceuticals in the health care sector, and from Energy Exploration & Production to a broad-based Energy ETF in the energy sector.

Trading with a hatchet is a colorful description of what the team calls beta trades. Beta trades can make a significant difference in the volatility of the overall portfolio. These trades typically involve buying and selling highly volatile risk assets to or from cash or other low risk assets. Over the past month we took out the hatchet rather infrequently to reduce risk, but we did execute a few beta transactions along the way. Examples of beta trades included selling our remaining commodity futures ETF position, buying a long-term U.S. Treasury bond ETF from cash, and selling High Yield bonds to cash. While these transactions had more of an impact on portfolio volatility than our scalpel trades, up until the past few weeks we were still trying to give the bull market the benefit of the doubt and the overall impact of our transactions was to get slightly more defensive as our view of the economic cycle began to change.

Last week, however, as the data clearly indicated that the economy is slowing, or perhaps slipping into recession, the scalpel was put away and the hatchet came out. In the past week we sold the Energy SPDR, Consumer Discretionary SPDR, Equal-Weight Industrials, and Gold ETFs, all with the goal of reducing our most volatile equity positions by a total of 10%. As of today we have 7% of the sales completed, and we are targeting the remaining 3% at an S&P 500 price of somewhere close to 1,250. Our models tell us that the hatchet has done its work well. Our best guess is that the beta of the DMG model is approximately 0.4, meaning we are gathering around 40% of the downside moves in the S&P 500 Index. With portfolio volatility properly managed, it may be time to take out the scalpel for the remaining 3% of our equity trades. If so, look for us to rotate within the U.S. equity allocaiton – selling a volatile, cyclical equity position to buy a more defensive position like Consumer Staples our Utilities.