Buy & Hedge Retirement Update: Rebalance - Risk Reduction – & Dry Powder

By Derek Moore

Overview

Many of you might have noticed some adjustments within ZEGA’s Buy &Hedge Retirement Strategy during the past few weeks.  The market was down 3.5% Thursday, but these adjustments were not the ZEGA trading team making a market call, rather this was part of a systematic approach where we periodically reduce some exposure.

This naturally occurs when markets have run higher (or even lower). The combinations of the adjustments we made; reducing some short duration high yield risk and reducing the long stock market exposure have positioned the strategy to be poised to take advantage of any material pullbacks.

Rolling Hedges to Take Profits

Those familiar with the Buy &Hedge Retirement strategy understand that instead of buying actual SPY shares, we use call options to control but not own upside in the S&P 500 Index. We create notional value and the resulting long call options go up or down a certain percentage compared to the overall market. As the market moves higher and further from the call options strike price they capture a greater percentage of that up move.  But as we know what goes up can go down, so as the calls appreciate in value, they are also creating more risk since they have more value.

So, what you saw was a call option rolling process where we closed the higher valued options (lower strike and time) and rolled up to less costly higher strikes to bring the exposure down. The benefit of rolling to higher strikes with more time is less risk in the event of a moderate or material pullback.

The various changes bring the strategy back within our internal target exposure ranges (we increased exposure when the market was down 30%), takes some profits, and reduces the exposure to moves in the market.

Reducing Short Duration High Yield Exposure

We utilize a short duration bond allocation as a funding source for the long market exposure, the long call options we just spoke about. The exposure was elevated after an increase in the allocation made back in April. But with the ETF’s recent move, the exposure had surpassed the model’s target. The high yield ETF: SJNK has rallied from its March lows, all the while paying monthly dividends.  Our return targets were met from a funding perspective given the ETF’s price moves from April to September. The SJNK exposure, which was also hedged the entire time with put options, was ratcheted back from 70%-90% of the portfolio to around 50% currently

A secondary factor is the Federal Reserve has been buying high yield exchange traded funds including SJNK. We like having the FED purchasing the same ETF we own.  

Adding Dry Powder for A Pullback

Finally, the other factor we adjusted was adding some shorter duration treasuries via the ETF: SHY. While the yield is much lower compared to high yield (SJNK), when markets selloff historically, treasuries get a bid up and act as a hedge. The idea here too is that should high yield pullback substantially, we have dry powder that we can quickly rotate back in at lower prices.

Summary

We know anytime there are wholesale adjustments you and your clients might appreciate some information on the framework and goals of those changes. Basically, we took some risk off, and created an opportunity to add risk on a material pullback. Again, this was not a market call where we thought the Nasdaq 100 Index would pullback around 5% and the S&P 500 around 4% in a single day. Simply, this is part of the ongoing management of the strategy in an effort to optimize the returns and risk profile for your clients.