The MarketGrader Risk-Managed Indexes seek to provide investors a measure of the capital appreciation opportunity in major stock markets that minimizes the negative impact of bear markets. Created in partnership with risk management specialist Kaizen Advisory, the series is desirable for investors seeking to follow the performance of the most fundamentally sound quality companies selected by MarketGrader's growth at a reasonable price (GARP) methodology while managing the large drawdowns and associated volatility inherent in the equity asset class.
The Risk-Managed Index series combines MarketGrader's core country indexes in select large equity markets with a tactical risk overlay from Kaizen Advisory. The Kaizen Dynamic Risk Overlay Index (KZTVOL) behaves like catastrophe insurance in times of systemic events, providing a payout when equities face sustained and significant selling pressure.
The Dynamic Risk Overlay utilizes a rules-based hedging technique that is automatically triggered under certain conditions common to past systemic events. The proprietary process is governed by market volatility, using the VIX and associated measures of stress to gauge the drawdown potential in equities. When the hedge signal is on, the given MG Risk-Managed Index allocates 30% to certain VIX futures contracts. In times of market stress, VIX futures increase in price as participants rush to hedge risk, typically providing uncorrelated returns with equities.
The rules-based hedging process is demonstrated below using the MG 100 Risk-Managed. Instances when the signal is on, causing the Index to allocate to select VIX futures contracts (long volatility), are shaded. As is seen, the hedge is typically triggered when spikes in the VIX occur. Elevated VIX levels represent expectations of heightened volatility and potential pressure on equities.
The Index never sells or shorts the selected MG Index; it is always long equities. This decreases risks associated with other hedging techniques. As measured by price returns on the VIX futures, the Dynamic Risk Overlay signal provides a positive return in roughly half the instances the hedge is applied. The performance drag on the Index of a hedge placed when VIX futures prices drop is a fraction of the positive contribution when VIX futures rise.
This replicable and systematic process delivers an effective hedge that is only applied tactically. Based on historical conditions since the April 2004 inception of the backtested results, the hedge has been activated 5% of trading days and about one quarter of months on an annualized basis.
Under normal market conditions, the hedge is not activated, allowing the proven strength of the growth at a reasonable price (GARP) stock selection methodology that governs MarketGrader's core country indexes to fully drive performance.
The Index construction has the effect of decreasing drawdowns, while the tactical nature of the hedge allows the fundamentally-sound quality companies selected by MarketGrader's GARP methodology to generate significant upside capture in normal market conditions. Over market cycles, this combination typically results in an improved risk/return profile.
To read about the MG 100 Risk-Managed Index, our diversified U.S. equity index utilizing the Overlay, see here.