Erez Katz, Lucena Research CEO and Co-founder
How to Minimize Exposure to Exogenous Events and Market Risks While Accumulating Holdings in a Position Over Time
Hedge fund investment styles, and the techniques used in their implementation can vary dramatically. One popular example is “event-based” investment. The concept is rather simple: anticipate inflection in a stock’s price as a result of an impending event with an unknown outcome.
As data and information become more accessible, the market has become more efficient. Consequently, the required lead time of an event-based investment has also grown longer. In other words, investors are seeking early entry in order to maximize lack of market awareness.
This is where fundamental research and algorithmic trading intersect beautifully. The idea is to gradually accumulate holdings in a particular stock ahead of the event date while minimizing risk against exogenous events and market risk.
Here I’d like to demonstrate a technique by which you can construct a hedge specific to a stock with one goal: minimizing downside risk while anticipating an impending event’s outcome.
What Types of Events are Popular for Investment?
An obvious example is earnings release dates. The dates in which earnings are published are public information, although earnings outcomes are subject to research and analysts’ interpretation. Through our partnership with Wall Street Horizon, we are able to access earnings date revisions ahead of the broad market. More about our partnership and derived signals here.
However, if an analyst has a strong conviction in earnings results ahead of the market, his/her portfolio could greatly benefit from pricing inefficiencies for entry ahead of the event or exit after the event.
In general however, events are not necessarily confined to earnings but rather to any corporate action such as bankruptcy, mergers & acquisitions, or FDA approval of a new drug.
Gilead Science GILD
Gilead Sciences, Inc. is an American biotechnology company that researches, develops, and commercializes drugs. The company’s research has yielded 23 marketed products that benefit millions of people. At the present time it holds a pipeline of late stage drug candidates for HIV/AIDS, liver diseases, cancer, inflammatory, and respiratory diseases.
The process by which a drug makes it to market involves pending FDA approval, which follows a successful phase III clinical trial. Once a drug is accepted by the FDA it typically takes 10 months or so to hear the FDA’s first assessment, which ideally would provide the path to commercialization.
Each stage of the clinical trial and ultimately FDA approval creates an event. The level of impact on the company’s stock price is predicated mainly on the intrinsic value of each drug to the market and the likelihood of a successful outcome. As you can see from the price chart of Gilead below, the stock has been rather volatile, making it favorable to a hedge fund looking to exploit such volatility.
GILD trailing 12 months stock price
A typical hedge of a single stock is buying protective puts or calls. However, traditional hedging techniques are less effective in this particular case for two reasons:
1. Due to the volatile nature of the stock the derivatives are typically more expensive.
2. Options are subject to time decay, and become worthless at expiration — not favorable, given the FDA’s tendency to extend the approval timeframe as it may request additional clinical information.
In practice, we are looking to leverage our GILD holding 2X and construct a portfolio in which 50% of its allocation is GILD and the rest is a collection of long/short positions that will serve as a hedge.
Step 1: Use QuantDesk’s Portfolio Replication to construct the hedge universe. The Portfolio Replication identifies a collection of stocks that together track a given time series formation. In this example, we are looking for large caps that track GILD’s performance over time. Our goal is to minimize tracking error.
The replicator identified mainly healthcare stocks that together move in tandem with GILD.
Step 2: Optimize the portfolio’s allocation for a min vol target. During the waiting period we are not looking to generate alpha. Rather, our goal here is merely to minimize risk while anticipating the impending event. We use QuantDesk’s Portfolio Optimizer to unleash the Nobel prize winning Markowitz’s mean variance optimization (MVO).
Optimizing a portfolio with 50% GILD and the remaining replica positions.
We’ve achieved lower volatility over time with the anticipation that such interdependencies (covariance) between positions will be preserved for some time in the future, when a new optimization will be required.
Step 3: Testing our hypothesis over time. QuantDesk’s Backtester allows you to validate various scenarios to optimize the above portfolio over a long period of time. The backtest results will indicate whether we’ve been able to consistently reduce GILD volatility under various market regimes.
Backtest results of optimizing the GILD replica portfolio over 6 years (since 1/1/2013).
The volatility as demonstrated by the max drawdown is ⅓ of GILD itself. The excess transaction cost is an important factor, so we’ll want to consider the frequency by which we optimize carefully.
It’s important to note that the above backtest is solely made to demonstrate the hedging function. It doesn’t consider exiting the hedge just before or after the event date in order to maximize the short term gains resulting from the event outcome.
The above example is a creative way to construct and test a hedge for a high risk portfolio. Minimizing volatility while anticipating a considerable move in a stock pending an event is a useful technique geared to minimize exposure to exogenous events and market risks.