Q: What is the history of the company and the fund?

Equinox was established in 2003, and its products reflect our belief that all investors should have access to alternative strategies that help diversify portfolios. In our view, these should not be the prerogative of high net worth individuals only.

We launched the EquityHedge US Strategy Fund in September 2013 to give retail investors the opportunity to reduce the risk to their core equity holdings through a hedged equity fund. Our strategy uses a dynamic hedging program that trades futures markets which are trending and negatively correlated to equities.

Q: How would you define your investment philosophy?

Our organizational philosophy is that everyone can and could benefit from alternative non-correlated strategies. Because these strategies tend to have low correlations with core holdings, they may effectively give better risk-adjusted portfolio returns. When offered in the form of mutual funds, we believe they may also have numerous advantages over hedge funds, including safe custody, regulation, liquidity, and relatively small ticket sizes.

Most portfolios have significant equity holdings because the perceived wisdom is they are a desirable asset class in the long run. Since 1926, when the CRSP data are available, the S&P 500 Index has grown at a compounded rate of just over 10%.

However, equities may be a volatile asset class subject to sharp and sudden corrections, and they generally contribute the bulk of risk in many portfolios. 

Historically, large-cap U.S. equities have had an annualized standard deviation or volatility of close to 15%. 

But even when an investor is holding a traditionally diversified portfolio with 60% allocated to equities and 40% to bonds, as much as 90% of that portfolio’s risk still comes from equities. 

Equities can go into very deep and sharp corrections as has happened twice during the past 15 years. When the dot-com bubble burst, equities had a 40% to 50% drawdown, peak to trough. Later, in 2008, when the equity markets fell again, investors lost close to 50% of their value from peak to trough. With the benefit of hindsight, if they have stayed in the market, they have more than made that back.

Although equities are an essential component of investor portfolios, we feel there may be a better way to access them than just being long. This is what our hedged equity strategy is all about. 

Q: How does hedging work?

By hedging equity exposure, the fund can provide better risk-adjusted return characteristics, by managing drawdowns and volatility. Potentially, it can also reduce the negative skew that typically characterizes equities, and give the benefit of convexity. 

When markets are going up, we hope to capture a lot of that upside. But when markets are going down, we try to restrict the strategy’s downside to 50% to 60%. 

Broadly speaking, equity exposure can be risky. The upside is always great, but the sudden sharp drawdowns can destroy a portfolio, albeit temporarily. Investors have tried to manage this risk in a number of ways.

One alternative is tactical timing, or having equity exposure in a bull market but moving to cash in a bear market. This involves forecasting, and it is very difficult to forecast movements in the equity market correctly. 

Typically, people who try tactical timing hurt their own performance. When the market is going down, they tend to panic out of it, when in fact this is when investors perhaps should be adding to investments. When the market has been on a tear, rather than taking profits off the table, investors tend to be propelled by greed and stay in longer than they should.

Another way to potentially reduce equity downside risk is by buying put options. But that can get expensive. For instance, when the market is going up, if someone keeps buying puts and rolling them forward, they will simply be spending on option premium. Put premia also tend to become more expensive when market participants are expecting a correction. 

Long-short equity, which lowers overall equity exposure by shorting individual stocks, is another alternative. Typical long-short hedge fund managers try to earn alpha by picking names that will sell off more than the market when the market is going down. Unfortunately, evidence shows that most long-short managers are much better on the long side than they are at adding value on the short side. Thus, shorting stocks may simply serve to lower the portfolio’s beta and not very efficiently at that.

There are other drawbacks to shorting stocks. The most overvalued stocks, like Amazon.com, Inc. during the dot-com bubble, are often expensive. Investors may need to pay to actually borrow these stocks and are open to buy-in risk if the borrow gets tight or dries up. 

It is difficult to execute long-short strategies well, and it is particularly hard for mutual funds to incorporate such strategies. Mutual fund structures limit how much a fund can be short, and there are also restrictions on incentive fees payable to mutual fund advisors. In our view, the best managers choose to stick with hedge funds, which have no such restrictions.

All these factors may mean that investors who use mutual funds may not be accessing the most efficient way to hedge equity exposure.

Q: What is your investment strategy and process?

With all this in mind, Equinox devised what we believe to be a “better” way to hedge equity risk and make it available to investors through this fund. 

On the long side, we buy S&P 500 Index futures. This is one of the least expensive ways to get exposure to large-cap U.S. equities.

On the short side, we add value through our expertise in the managed futures arena. As an asset class, managed futures strategies have essentially been uncorrelated to equity markets over long periods. Adding them to a portfolio lowers its overall volatility. 

But in themselves, managed futures are not a hedge for equities because they have close to zero correlation, and a hedge is defined as an instrument that has negative rather than zero correlation. 

We use a systematic and dynamic hedging strategy based on models developed by one of our commodity trading advisors, Quest Partners, which has 25 years of expertise in managed futures. They have constructed the hedge program in consultation with us and they execute the trades

The Quest dynamic hedging program looks for two properties in futures markets: trending markets, whether they are in fixed income, currencies, or equities; and negative correlation to U.S. equities. 

The hedging program is completely systematic. It uses trend models with three lookback periods – short, medium, and long. These are filtered to pick markets which are negatively correlated to U.S. equities, and then the models establish long or short positions in those markets. 

For example, if the Japanese yen is trending in the short-term and is negatively correlated to U.S. equity, the program would use a long position in yen to hedge a falling U.S. equity market. 

Our hedging program is also dynamic. If equity markets are going up, the hedge tends to stay on the sidelines. In fact, the hedge can be up to 10% long, so if there is a strong bull market, the fund can have up to 110% exposure to equities. 

The hedge can be up to 50% on the short side. When the hedge is 50% short, we are effectively 50% long because the S&P 500 exposure is 100% of the fund. Obviously, when the market is going down, the fund is going to earn a negative return. But when the equity market is down 20%, the fund may be down about 10%. 

At the same time that beta is being reduced, the hedge has the potential to earn alpha through trending markets. Our belief is that by putting on this systematic, dynamic futures hedge, the end result is a better risk-adjusted return. This has been the case during the recent drop in equities during the Brexit crisis. 

By providing less downside and most of the upside, we seek to effectively offer positive convexity. Also, by layering this hedge on top of the U.S. equities, the fund returns should have lower negative skew, because the hedge tends to have positive skew while equities generally have negative skew. 

Q: What are the components of your hedging strategy?

The hedging program has three components: 

1.    Equity Index Timing Component: Uses classic trend-following techniques to be short/flat up to 18 global equity index futures over three time-frames (short, medium, long). This component provides protection during sharp equity market downturns. 

2.    Market Momentum: A diversified long/flat/short global financial futures portfolio (18 equity indices, 19 bond and short-term rates, 9 currencies) that uses covariance-filtering to put on negative β trades in trending markets. 

3.    Beta Range Stabilization Component: Fine-tunes the overall portfolio β to stay within our specified range of 50% to 110%.

About two-thirds of the hedging program’s benefits tend to come from the Market Momentum Component, and one-third from the Equity Index Timing Component. Together, these two components generate returns that tend to have about a −70% correlation to the S&P and a beta of about −0.90 vs. the S&P. In addition to mitigating equity market drawdowns, the hedge can potentially also lower the overall volatility of the hedged equity portfolio by around 25%. Lastly, the hedge potentially adds positive “left tail risk” or skew.

Q: What is your research process and how do you look for opportunities?

The long side is very simple. If someone invests $1 million into the fund, we buy $1 million of exposure to S&P 500 Index futures and then put on the appropriate amount of the hedge. Thus, the effective exposure to equity markets will range from $500,000 to $1,100,000, or 50% to 110%. 

Our research is more in terms of adding different markets, making sure the markets traded are liquid, and analyzing the performance of hedging models annually. If minor tweaks are needed to the hedging program, they are primarily done by our CTA partner, Quest, in consultation with us. 

Q: How do you construct your portfolio?

There are 46 different financial futures markets within our opportunity set: 18 equity futures, nine foreign currency futures, 14 bond futures, and five short-term interest rate futures. Each market is treated individually, and each uses a short-term model, a medium-term model, and a long-term model.

We believe that having such a large opportunity set provides many opportunities for hedging equity risk and potentially earning alpha, and adding positive skew, and convexity.

At any given point, the actual futures positions in the hedging program depend on trends and correlation to the equity markets. The overall average beta of the portfolio over a market cycle is expected to be 60% to 80%. 

The fund has no set benchmark because its exposure varies. One appropriate benchmark might be 70% of the S&P 500 Index, and we do look at the HFRX Equity Hedge Index as well.

Q: How do you define and manage risk?

The fund’s dynamic hedge has the potential to lower overall volatility by approximately 25%. If S&P 500 long-term volatility is 16%, then the fund will have an average volatility of 12%, or 75% of the volatility of the U.S. equity market. 

But that is only one measure of risk. We also consider peak-to-trough drawdowns. As I’ve said, in the last 15 years, there were two drawdowns in the 40% to 50% range, and those are harmful to investors in many ways. In particular, when equities fall 50%, they need to rise by 100% just in order to get back even. This is the negative aspect of compounding! 

By putting on a hedge primarily when needed—when equity markets are trending down—the fund reduces beta dynamically and could help investors essentially cut losses by about half while trying to maintain high market exposure during rising markets. 

The overall return properties of the portfolio tend to be much less negatively skewed than equity markets by themselves. Many investors are unaware of, or ignore, this left-tail or skewness risk, but we think it is significant, and our dynamic hedging strategy helps manage it.