Factor Spotlight
Factor University

The Inherent Volatility of a SPY Hedge

This week we’ll be kicking off a series on “smart hedging,” by which we aim to find a more efficient and elegant solution to hedging market exposure in your portfolio. We’ll also provide our weekly market and factor update.

The Limitations of the SPY Hedge

In our many conversations with investment managers about their portfolios, the most common hedge being implemented is the S&P 500 SPDR (SPY). Funds the world over use the purest representation of the US stock market to hedge market exposure in their portfolios, while being completely unaware of the inherent drawbacks in this approach.

We pulled the AUMs and short interest % of a broad list of ETFs, and determined that almost 40% of the SPY’s $274B in AUM is tied up in short interest, not even including derivatives. This confirms our view that the SPY is the most obvious instrument being used as a hedge in the investment world. The problem is that funds also have factor exposures that are affected by using the SPY as a hedge.

SPY & Volatility

While it sounds counterintuitive, did you realize that when shorting SPY you are actually increasing your portfolio’s exposure to the Volatility factor? Most funds don’t understand that by adding a SPY hedge to mitigate market exposure, they’re also making a positive bet on Volatility. Here is what the SPY’s exposure to Volatility has looked like over the past five years:

SPY Volatility Exposure: 10/17/14 - 10/17/19

Because the SPY has been underweight Volatility throughout this entire period, a short position in the SPY would mean you’d always have been long Volatility.

This is problematic, because Volatility has built-in negative premia. Here’s what cumulative return for Volatility has looked like over the past five years:

Volatility Cumulative Return: 10/17/14 - 10/17/19

Vol returns T5Y

If we take a look at the affect that being short Volatility has had in terms of performance for the SPY, we can see that this relationship has yielded +4.7% positive return for a long SPY position over the past 5 years.

SPY vol perf contribution

In other words, if you were short SPY for the past 5 years, you were losing 94 bps per year in real performance, just because you were using SPY as a hedge! Thus, we can conclude that SPY might be a good market hedge, but is clearly not an optimal factor hedge.

So when we talk about making “smart hedges,” we refer to using a sharper tool rather than a blunt instrument in order to not just mitigate market exposure, but also simultaneously hedge out risks to improve overall performance.

Next week, we'll show how you can leverage Omega Point's optimization engine to build a simple, custom basket of names to emulate what most managers are trying to accomplish with the SPY (reduce market exposure), while eliminating exposure to Volatility as well. Ultimately, we'll show you how you can turn that loss from SPY factor exposure into an alpha.

Market and Factor Update

US Market (10/11/19 - 10/17/19)

US market 20191017
US Stock Market Cumulative Return: 10/11/2019 - 10/17/2019
  • The market had a mostly good week, buoyed by a positive start to earnings season as around 70 companies reported this week, with 80+% posting better-than-expected results.
  • Investors shrugged off data showing that China’s economic growth slowed more than had been expected - 6% in 3Q vs. the 6.2% pace established in 2Q, driven by weak business investment.
  • Stocks also saw gains Thursday after UK and EU leaders announced a tentative Brexit agreement, but that deal still faces significant challenges ahead of a debate and vote on Saturday.
  • U.S. retail sales fell for the first time in seven months in September, with the biggest declines coming from auto, building materials, and online purchases.
  • Investors will continue to focus on corporate earnings, US - China trade headlines, and the upcoming Fed meeting.

US Model

US Table 20191017
Methodology for normalized factor returns
  • Size saw a considerable rally over the past week, moving up half of a standard deviation.
  • Momentum continued to revert after the crash in September, when it hit a trough of -2.98 standard deviations below the mean (9/20).
  • Market Sensitivity and Volatility both saw gains on a normalized basis after a period of weakness, signaling that risk-on is back in vogue.
  • The recent strength that Profitability had seen appeared to wane a bit as it crossed into Overbought space, after hitting a trough of -0.27 standard deviations below the mean on 9/24.
  • Growth has continued its bounce off of a low of -1.88 SD below the mean on 10/1.
  • Value continued to revert away from it’s recent peak of +2 SD above the mean (9/30).
  • US Total Risk (using the Russell 3000 as proxy) saw a slight decrease of 17 bps.

Worldwide Model

WW table 20191017
Methodology for normalized factor returns
  • As we’d seen in the US, Size was the biggest gainer this week as it gapped up on a normalized basis away from the mean.
  • In the worldwide model, Earnings Yield also saw strength as it now approaches Extremely Overbought territory.
  • Momentum continued to see strength after hitting a floor of -2.51 SD below the mean on 9/23.
  • Market Sensitivity saw a decent move up (0.33 standard deviations), while Volatility started to climb above the mean.
  • Global Risk (using the ACWI as proxy) saw a move up intraweek and ultimately settled at 13.08%.


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