The KP Models manage equity market exposure — systematic risk and systematic reward

The Models certainly don't do this perfectly, but they do it more than well enough, especially given time to overcome short-term statistical noise that is inherent in financial market dynamics. The question then becomes, "what should an advisory organization do with this information?"

Hedge Overlay on Existing Policy Portfolio. In the most straightforward application, our client says in effect, "'we remain committed to the value-added proposition (long portfolio strategy) of our organization. We don't want to change our message at all. We would just like to install a background buffer to mitigate market risk."

Risk Overlay Portfolio Mechanics. The investment policy is modified to allocate a portion of a client portfolio to a segregated risk control portfolio, usually labeled a Risk Overlay Portfolio. In a typical structure, the base portfolio would take up perhaps 70%-80% of the client investment and the overlay 20%-30%. Allocations are periodically rebalanced.

In upward-trending markets, as they are defined by our trend-identification process (the green intervals illustrated on the Model Chart), the overlay fund's allocation is invested in market index funds that track the base portfolio. When the Model detects the possibility of stormy weather, the hedge sub-portfolio shifts to cash or (preferably) an inverse index position. The process is rules-based and applied stricly, with discipline.

The mathematical impact of converting this Risk Overlay Fund (market hedge sub-portfolio) from a positive to a negative beta produces a very significant shift in the client's exposure to market risk, with a high likelihood of reducing portfolio drawdown and enhancing returns.

Long/Short Index Portfolios. The stream of KP long-short signals taken on their own are capable of guiding index-based absolute return strategies (i.e., without being blended into the background of a conventional, long-only portolio strategy). Several of our RIA clients operate long-short strategies guided only by our Model's output.

Double Alpha Strategies. Finally, it has also been interesting for us to blend our process with other tactical absolute return strategies that demonstrate alpha using a approach uncorrelated to ours. Combining two independent alpha-generators in one portfolio – more or less as equals – gives full benefit to the dynamic of offsetting volatility, and almost always produces higher Sharpe ratios than either strategy on its own. We are incubating several such strategies here in mid-2011, and can provide Fact Sheets and (limited, but audited) track records for these portfolios.