Summary

• Since its May 29th 2014 Seeking Alpha publication, the strategy has performed famously.
• I have urged readers to stop using this strategy index.
• Few have heeded my warnings.
• The strategy continues to crush the stock market.

On May 25th, 2014, I published a book on Amazon Kindle which outlined a strategy with two attributes I hold dear — the strategy had to massively outperform the market and the strategy had to be easy to implement. The book was based upon combining two sub-strategies we had invented, called Structural Arbitrage and Hedged Convexity Capture. We have been writing about both strategies for years.

Simply put, Hedged Convexity Capture seeks to capture the negative convexity associated with the daily reset of leveraged inverse ETPs. Structural Arbitrage seeks to sell expensive insurance on equities and to statistically or synthetically reinsure, or lay-off, that risk more cheaply.

Today, we will examine combining both strategies, as we did before. To work, a strategy needs to be simultaneously well constructed and hated, to give maximal performance. Literally, other people need to take the other side of the trade and lose money when doing so.

For example, when I first wrote about the strategy on Seeking Alpha, the comments were highly negative. Comments such as The strategy looks great on paper but once you factor in the borrow fee and the frequent rebalancing it loses its luster and LTCM much? set the tone for much of the comment section. And that’s OK. It takes many divergent opinions to make a market. And indeed, I personally do not like strategies with open-ended tail risk, and do not allocate sizeable positions to strategies which utilize shorting.

However, convexity is an incredibly important concept. And capturing convexity can generate a highly robust return stream due to the daily reset of leveraged ETPs. The reason that capturing convexity is so profitable is because a return can be generated when the underlying indices go sideways, because of the daily leverage reset.

And because markets often go sideways, this gives a well-designed convexity capture strategy multiple ways to profit. But as I have stated again and again. readers should close out their positions in the strategy and go to the beach.

However, the strategy has continued to crush the market even though it is among the very least sophisticated that I have ever created. To review, here are the integrated strategy’s rules:

1. Short the VelocityShares Daily 2x VIX Short-Term ETN (NASDAQ:TVIX ) or the ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY ) with 25% of the dollar value of the portfolio.
2. Short the Direxion Daily 20+ Year Treasury Bear 3x Shares ETF (NYSEARCA:TMV ) with 75% of the dollar value of the portfolio.
3. Rebalance weekly to maintain the 25%/75% dollar value split between the positions.

Here are our testing results in a linear scale since I first wrote about the strategy on Seeking Alpha on May 29th, 2014:

The strategy does 34.9% vs. 10.9% for the SPDR S&P 500 Trust ETF (NYSEARCA:SPY ) over the same time period, before borrowing costs. And this false notion that borrowing costs would decimate the strategy’s performance is totally ridiculous, given the level of outperformance demonstrated. Many readers who use Interactive Brokers have told me that the margin rates are very reasonable in relation to the outperformance generated. The MAR ratio and the Sharpe ratio of the strategy index are far superior to that of the SPY. And the strategy has a moderate correlation to the equity markets.

Literally, the strategy is selling volatility while seeking to statistically reinsure, or lay-off, that risk cheaply in the 20-30 year government bond market. Simply put, the strategy sells a very expensive form of insurance, then seeks to reinsure statistically with a cheaper form of insurance. The logic behind this is that 20-30 year government bonds often move (but not always) inversely to the stock market. This provides a statistical hedge. And unlike puts or volatility, which melts in one’s hands like ice cubes due to time decay or contango, long-term government bonds are an asset, so they are statistically a cheaper form of hedging than volatility or puts.

However, this statistical relationship will not always persist even though it happens often. A simultaneous equity and bond bear market would hurt the strategy, as well as discontinuous moves in markets which cause one of both legs of this strategy to explode upwards, leading to open-ended risk.

Personally, I believe that volatility could rise and bonds could fall in the near-to-medium future. Therefore, I again recommend that investors stop using this strategy.

An interesting further area of R&D would be to determine if protective call options on UVXY or TMV could be purchased to make the risk of the strategy closed-ended, rather than open-ended, without causing much performance drag. In addition, a trailing stop on the entire strategy should be explored, along with re-entry rules.

And I am not recommending the use of this strategy index. The strategy index is merely a public demonstration of the notion that two ETPs, well chosen, can vastly outperform the stock market, with only a moderate correlation. The strategy has generated massive alpha until very recently.

The notion that one can only beat the market with a handful of well-chosen stocks is totally wrong. In fact, the opposite is true. In the very near future, an ETF or mutual fund, which uses a quantitative, or AI-based strategy index, will far exceed the performance of human managers. That moment will change the investing world forever.

That is our macro view of the investment management industry, and we have been working diligently to make that vision a reality through the creation of new technology. And when it does happen, it will be the shot that’s heard around the world. Quant methods and AI will do for investing what robots will do for surgery.

I have demonstrated that our technology (even a simple publicly disclosed version of it) is totally capable of beating human managers. Our strategy indices are based upon clear, objective, systematic rules, which can be easily replicated and verified, as I have shown. We wrote an article about the strategy months ago, and have revisited the strategy since then. It’s a true walk-forward demo.

My vision is the creation of an ETF or mutual fund firm which could go head-to-head with BlackRock (NYSE:BLK ), PIMCO, Fidelity, and Bridgewater and win assets through performance, rather than marketing. Such a firm could have dramatically lower costs since it would rely upon rules-based strategy indices rather than discretionary management. Not only is such a vision possible, but also it is eminently predictable as computing power explodes.

I suppose that some buggy-whip manufacturers were entirely uninterested in cars and promptly went out of business due to their complacency. What will you do to meet the challenges of the future? If you were a professional portfolio manager, would you want to be benchmarked against even better technology than this?

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in UVXY, TMV over the next 72 hours. (More. ) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.