I must admit that I have been having a lot of fun lately. Not the kind of fun you are probably thinking about; it was more the kind of fund that results from satisfying a curiosity as to what might happen when various scenarios are applied to an investment discipline.

Sine I published my free e-book “The SimpleHedge Strategy” back in March, a lot has happened it terms of uncovering the enormous possibilities that exist when using such an approach. Today, I will share one of those results with you, and I’m sure that it amazes you as much as it did me.

A few weeks ago, I finally received my custom made program, which quickly lets me analyze any period in history (for which data exist, of course) to see if a hedged approach using ETFs and/or no load funds would have made sense or not.

I’ve been mainly focusing on testing scenarios in this century since it offered us two devastating bear markets that have clearly demonstrated the short comings of just about all of the canned asset allocation approaches.

Since ETFs were not available for most of the period, I have substituted them with no load funds (or load waived funds). The goal was for me to see if and how my SimpleHedge approach would work when pitted against the S&P; 500 index by using an S&P; 500 no load mutual fund.

For the short side of the hedge, I selected BEARX, and on the long side I randomly picked PEOPX, both of which have data going back to 1996.

I ran the numbers to generate yearly returns, including reinvested dividends, and this is what I came up with:



I was pretty amazed when I saw those results. How is this possible? Simple. The key is NOT to buy-and-hold the hedge, but to rebalance it appropriately as described in my e-book.

Rebalancing is the key to all success when using my hedge approach since it locks in profits and minimizes losses. If you look at the numbers above, you’ll notice that the “feast or famine” type of investing so prevalent in buy-and-hold scenarios has been smoothed out. In this example, the returns are steady and while big drops are eliminated (2002/2008), so are big gains (2003).

However, as you can see, it is not necessary to have high gain years such as 2003, which are simply neutralized with the next downturn.

I am not saying that this is a scenario you should use; I am merely pointing out what can happen if you apply a hedge discipline over a period of time during which most investors and professionals lost when using the S&P; 500 as a benchmark.

I have no positions in this hedge, although I am using BEARX with other hedge combinations. I have found a number of hedges I am currently using that have produced twice the return of the above BEARX/PEOPX combination, which means that they are on par with returns that most investors only hope to get with straight long positions.

In my advisor practice, I use hedges along with outright long holdings depending on our trend tracking signals and have found this to be a great combination for most clients.

The point of all this is not to discard a hedge approach as something inferior. My work has shown that hedging can offer great upside potential with severely limited downside risk, which is what most (not all) investors are looking for.

My latest No Load Fund/ETF Tracker has been posted at:

http://www.successful-investment.com/newsletter-archive.php

Trading around the unchanged line made for an uneventful week.

Our Trend Tracking Index (TTI) for domestic funds/ETFs has now crossed its trend line (red) to the upside by +1.65% keeping the current buy signal intact. The effective date was 6/3/2009.



The international index has now broken above its long-term trend line by +10.93%. A Buy signal was triggered effective May 11, 2009. We are holding our positions subject to a trailing stop loss.



[Click on charts to enlarge]

For more details, and the latest market commentary, as well as the updated No load Fund/ETF StatSheet, please see the above link.

On Wednesday, the markets did a repeat performance of Tuesday by selling off early and staging a nice rebound in the afternoon. Nothing much changed in terms of our invested positions.

Today’s hat tip goes to Mish at Global Economics for posting a video, which tries to answer the question how some of the trillions of dollars that have been spent are being accounted for.

I had to listen to it twice, because I just could not believe that so much ignorance and incompetence actually exists.

It left a bitter taste in my mouth, and I’m still wondering if anyone is really in charge or feels some sense of responsibility.

Take a look:

The WSJ featured an interesting article titled “Spice Up the Index-Fund Formula:”

Smart investors have long known that steady, boring index funds offer excellent long-term performance. But a twist on the tried-and-true indexing formula may juice returns — especially if smaller stocks continue to lead the market back from the crash.

“If you’re worried about over-concentration [in a few stocks], you might consider an equal-weighted sector fund,” says Matt Hougan, editor of IndexUniverse.com. “If Exxon Mobil were to announce something awful and its share price drops — but it has nothing to do with the energy market — and you were invested in the Dow Jones US Energy fund, you’re going to take a major hit. In an equal-weighted fund, it would have a much lower impact.”

To me, reducing volatility in the overall index, when a major company makes a earthshaking bad announcement, is something positive. This does not mean you can blindly buy and hold equal weighted funds; you still need to apply a sell stop discipline to guard against the market reversing its trend and moving into bearish territory.

In my advisor business, I favor using equal weighted ETFs like RSP in conjunction with my hedge strategy, since they tend to give us a better performance compared to the plain vanilla S&P; index.

Things looked bleak Monday morning as the Dow surrendered some 130 points before storming back in the last hour to wipe out all losses. The only negative about the comeback was that it occurred on very low volume.

It’s been a recurring theme lately that early bearish tendencies did not hold, and the bulls ended up in the driver’s seat.

Yesterday’s late buying was triggered by Nobel Prize winning economist Paul Krugman, who commented that the U.S. economy may start to emerge from the recession in September. This hopeful outlook turned what appeared to be a rut into a rebound rally. Go figure.

Not much changed with our Trend Tracking Indexes (TTIs), which are now showing the following positions:

Domestic TTI: +0.50%
International TTI: +8.84%
Hedge TTI: +0.45%

We are holding all positions subject to our sell stops.

While I have discussed the use of sell stops and occasional whip-saws on several occasions, reader William had this to say:

I am following your guidelines and have started to cautiously invest a small portion of some of my IRA in some ETFs. I am putting a 7% trailing loss on them.

Let’s assume that my fund loses 7% of its value from its high, and we are still over the trend line and the market then starts going up again. I have sold the fund, what do I do with the money? Buy a different fund, reinvest it in the fund (at what point)?

Or is this a scenario that won’t happen realistically?

Also, another scenario is that we are under the trend line when my 7% trailing sell stop hits. I then reinvest when it goes back over the trend line, right. This could happen multiple times so I could loose up to 7% of 1/3 of my portfolio, then up to 7% of 1/3 of what is left of that etc. That starts adding up to real money real fast. I guess that we hope that out fund goes up at least 7% after we buy it so we at least sell at a neutral.

I hope this market finds real direction!

While all these things you describe can happen, they usually don’t. There are some precautions I take to minimize the possibility of a whip-saw signal. For one, I don’t jump in the market the moment one of the Trend Tracking Indexes (TTIs) crosses its long term trend line.

I want to make sure that the trend line is clearly penetrated by +1% as well as by waiting a few days to make sure the TTI remains above it.

For example, when the international TTI generated a Buy on 5/11/09, it had fulfilled those requirements before I actually pulled the trigger. We allocated 1/3 of portfolio value, and our positions subsequently gained over 8% before coming off their highs by -4.16%. This means if I implement the sell stop after a drop from the high of 7%, I will come out ahead by +1% or thereabouts.

The domestic TTI generated a new Buy signal on 6/3/09. If you missed that exact entry point, it’s no big deal yet since the market has not moved much, and you can enter at a later time.

As I’ve said repeatedly, missing a buy signal is not as crucial as neglecting a sell signal. The former will only cost you potential profits, while the latter can have a serious impact on your portfolio.

If you get stopped out at the worst point with a 7% loss that means, if you had only 1/3 of your portfolio invested, the impact on the total would be -2.33%, which is reasonable. Even if that happened 3 times in a row (unlikely, but possible), you will have lost 7% of your total portfolio. While you may not like it, it sure beats the alternative, which many investors experienced in 2008.

Once you’re back on the sidelines, the proceeds should be in money market. If the market stages a recovery, and the trend line is crossed again to the upside, repeat the process.

If you been stopped out prior, and the market turns on you and resumes the up trend, you have a decision to make in respect to re-entry. If I liked the fund/ETF I had chosen, I re-establish my position after the old high has been taken out. Remember, the idea of following trends is to be onboard when the trend is intact and not try to bottom fish when things head south.

Above all, you need to keep in mind that this is not an exact science or an engineering problem to which there is only one correct solution.

At major inflection points, when trends change, the danger exists that whip-saws will become part of the equation. Investing always involves an element of risk no matter what you do, but I have found that these ideas are suitable for most investors, because they contain a blue print to follow, although it may be far from being perfect.