2020 was such a unique year that it will be part of the memory for eons. We saw the quickest bear market followed by an equally sharp rally, likes of which haven't been seen in generations. This rally, driven by the Federal Reserves' money-printing policy, not only attracted new investors but also emboldened them to take leveraged investments through highly risk instruments like options. A totally new class of investors entered the market who had previously doubted the equities since the 2008 great recession. The recent performance has led many new investors to consider trading as a full-time profession because investing is easy. On the other hand, seasoned investors who had performed very well over the years lagged the markets.
Over the past couple of weeks, I have been reading about the lack of performance of many established investment managers and their rationale. Most of their losses were attributed to the fast-moving markets, and some were linked to models not built for this kind of environment. For us, we have been performing a deep dive analysis into our performance which involves:
Evaluating every single trade and the performance driver
Identify what went well and areas of improvement
Incorporating any lessons and enhancements into the model
Evaluating the performance of the enhancements to ensure they work individually and collectively as part of the broader investing schema
This is an exercise that we normally do every year to ensure that we are continuously enhancing our investing algorithms. However, this year it was special. Penta Capital was also impacted by increased volatility. While our base model remained positive, other investment strategies under-performed. To summarize, there were two primary culprits:
Hedging Strategy
Allocation approach
The hedging strategy resulted in negative performance because of extreme volatility which made options extremely expensive. When there is volatility, a strategy needs to adapt quickly. Historically, we had not seen this high and persistent volatility. As a result, the model was trained for a different type of market. We have continuously evaluated and enhanced the model throughout the year to adapt to the high-volatility situation.
Before we discuss what went well, let's look at some investing lessons (some of these we already knew but were reinforced):
One cannot and should not assume what the market will do, rather have an effective plan for all possible scenarios
Human emotions can wreak havoc on investing
Federal Reserves is a powerful institution but all actions can have unintended consequences which will show up in other areas
Sentiment extremes don't always result in a correction. And corrections don't have to be through price. It could be via time. It is difficult to know what will unfold at any time.
Let's see what went well in terms of performance
The first two months of the year were very good.
In February 2020, we anticipated a sharp decline and positioned with hedges. However, the decline was more severe than expected. The ability to hedge was enabled by the hedging algorithm introduced in 2019 based n 2018 learnings.
Maintaining longs in April and May even after the market triggered a bear market due to the algorithm's mean reversion routine
Higher allocation in Gold and Gold Stocks, especially from May through August, and then reduced allocation in September onwards. It was driven by the algorithms ability to allocate between the asset and underlying instrument and enhanced by cyclical timing
Reduced allocation from Bonds in May/June, and August through December driven by timing and momentum algorithms
Anticipated a sharp decline in the stock prices in September and October driven by sell signals.
The model predicted and positioned for a sharp rally right before the election due to a buy signal
Minimal correlation with equities and other asset classes
Areas for Improvement
Hedging: Premature reduction of hedges in March 2020 before the bottom. And then continued hedging after March Bottom till August which reduced gains. This also resulted in a loss of premium
Reduced equity exposure as a systematic bear market signal was triggered driven by historical market characteristics.
Speculative positioning in September driven by a sell signal resulted in a compounded negative impact towards the end of September and in early October.
Pre-emptive positioning per proprietary signals
Premature reduction of longs after the initial November rally
Enhancements
Addition of the proprietary timing algorithm
Improved Hedging strategy with synthetic hedges
Improved market definition and related criteria
Results
Since we have been working on these evaluations for the past few months, I am pleased with the results. By the grace of the Almighty, we have incorporated these enhancements into the investment strategy. With these enhancements incorporated, the 2020 performance would have been significantly better than equities with 0.35 correlation and 1/2 of weekly standard deviation.
If I look at the investment approach, it is much more dynamic and proactive with a shorter-term risk-management mechanism as compared to the original that had a longer-term frequency. This is an evolutionary journey and we look forward to an even more objective investment tool and using it in 2021.
2021 will likely experience continued volatility at least in Q1. There is also a significant possibility of a major market top in the 2nd half of 2021. We will review the market conditions for 2021 in the next few updates.
Feel free to reach out with any questions.
Wish you a very happy new year. May the new year bring lots of joy to you and your loved ones.