Quant Investing : Inflation Hedge Improvement
In Hedge Interest Risk in High Inflation Environment, we present a simple combined strategy that aims to eliminate interest rate variation in inflation-protected treasury and takes the inflation-only risk by longing inflation-protected Treasury ETF and shorting regular Treasury ETF. We introduce both long-term and medium-term combinations. The long-term combination provides a better return but takes more risk.
This work implements a switching strategy that has compatible advantages of both combinations. Using the volatility spread between both combinations as an indicator, the strategy can switch between the two combinations based on the market’s attitude toward inflation.
Table 1 display the performance of the switching strategy in 2021. The switching strategy can achieve higher returns than the medium-term combination while effectively reducing the volatility of the long-term combination, with the best Sharpe ratio among the three strategies.
| Switching Strategy | Long-term Combination | Medium-term Combination | |
| Annual Return | 14.12% | 11.93% | 8.87% |
| Volatility | 5.68% | 8.45% | 4.05% |
| Sharpe Ratio | 2.48 | 1.41 | 2.19 |
To adapt to different inflation environments, we put the switching strategy together with our inflation indicator. In high inflation, we invest positions on the switching strategy, and in mid and low inflation, we hold cash rather than invest in the strategy.
Figure 1 shows the performance from 2011 to the end of 2021 and the values of the inflation indicator. Using the switching strategy can bring better returns. However, when we examine closely, there are some cases when inflation begins to fall from high inflation situation, the strategy return will be significantly hurt.
Therefore, the next task is to create a new indicator to correctly detect the signs of inflation decreasing and find the exact exit point. Here we use a simple but effective way, that is, to observe the change of the slope of the switching strategy. We named it a timing indicator, which points the upward and downward trend of the strategy.
The usage of timing indicator is to put the position into the switching strategy when the trend is up and hold cash on the contrary. We demonstrate the performance in 2021 in Table 2 after adding the timing indicator. Even in a high inflation environment throughout the year, adding this indicator can still bring the strategy performance to a higher standard with a comparable return, lower volatility, and superior Sharpe ratio.
| Switching Strategy | Switching Strategy w. 5-day indicator | Switching Strategy w. 10-day indicator | Switching Strategy w. 15-day indicator | Switching Strategy w. 20-day indicator | |
| Annual Return | 14.12% | 13.58% | 14.98% | 16.81% | 13.39% |
| Volatility | 5.68% | 4.66% | 4.27% | 4.17% | 4.20% |
| Sharpe Ratio | 2.48 | 2.91 | 3.51 | 4.03 | 3.19 |
Figure 2 shows the results since 2011; the timing indicator has played an excellent role again, successfully avoiding the downside period that the switching strategy faced during declining inflation. The figure 2 and table 1 show the outcome of timing indicators with different cases. Although not the best performing one of the indicators, considering the transaction cost and strategic stability, the 20 days indicator is a suitable choice.
Contact us at info@gammaparadigm.com for the full report.
Petty Chen
AVP of Quantitative Finance, Gamma Paradigm Research
LinkedIn
