Short Low Rank ETF Still Good Hedge

I spent a little bit more time to dig into the problem whether shorting lower ranked stocks or ETFs is a good hedging strategy. The data I got yesterday are on the bottom 20 stocks. If you still remember what I have discussed in my post on effectiveness of fundamental ranking, you will know that those stocks' ranks are below 1. They are not good hedge because they are garbages, and when the market turns from bear to bull, the rising tide lifted garbages a lot faster than those boats, i.e., stocks with higher ranks. Miserably you will see the market rallying while your portfolio falling if you short the garbages as a hedge.

But currently the sector ETF with the lowest rank is XLF. Its rank is around 20 as discussed in my post on ETF ranking. The question is whether rank 20 behaves like garbages or boats. If it is like boats, it may still server as good hedge.

In my post on effectiveness of fundamental ranking, I only calculated the estimated annualized return of the upper half of the spectrum: from rank 100 to rank 50. Using the same method, I calculated the return of the lower half. The result is shown in the chart below. Unlike the upper half where the best curve fit is 1/x^4, the lower half's best least square fit is a straight line.

On the chart each point represents a group of 100 stocks. The lowest 100 stocks, rank 0 to 3, still behave like boats. They are the worst performing stocks in the spectrum. So the garbage is only the lowest 20 stocks? To answer this question, I calculated the return of the lowest 50, 20, 10, and 5 stocks.

The bottom 50's return is lower than that of bottom 100. But bottom 20 is a lot higher, and it go up steeply all the way to bottom 5. So really the garbages are the bottom 20. No wonder I see such a bad performance when hedging with them.

Some key take away:

• The bottom 20 stocks behave like garbages, one should never touch them, no matter long or short.
• The market neutral strategy mentioned in ETF ranking would still be a good strategy if the shorted ETF's rank is above 15.
• One can short an ETF with low rank to hedge a portfolio with top k stocks, as long as the shorted ETF's rank is above 15. But that would be a little bit too complicated. In this case, short SPY may be a simpler hedge.

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