COVES: The Paper, The Proposal, and An Example
We’ve been away for a little bit longer than usual, but it was all worth it! We just finished up a new strategy and put the results up on SSRN (and are currently working on a follow-up to our “Kings of The System” sports analytics paper from a couple years ago, stay tuned!). However, we couldn’t just discuss the results themselves: this work required a little bit more discussion to fully encapsulate what we’re attempting to provide. Please enjoy the discussion of the paper, a proposal relating to a potential productization of the COVES strategy, and a quick dive into a potential application of COVES to a struggling country that does not have a stock market of its own.
The Paper - Buy Local: Creation of a Robust Long-Term Single-Market Equity Strategy via COVES (Country-Oriented Volatility-Enhanced Strategies)
The full paper is available on SSRN and can be found here: Buy Local: Creation of a Robust Long-Term Single-Market Equity Strategy via COVES (Country-Oriented Volatility-Enhanced Strategies). Now, I’ve already written over 5,000 words on the topic itself and I do not plan on mostly rewriting the same thing in this post, so I’ll attempt to cover the broadest strokes of the paper and leave you to read it to fill in the rest.
Remember CEILING and GAIA? They’re our way to provide a global equity strategy that focused on grouping equities by country and then quantitatively identifying the countries with the strongest probability of performing well in the near future…sort of like a CAPE ratio on a much quicker timescale. This was done to combat against home country bias and the overinvestment in one’s own domestic market: GAIA allows someone to hold an ex-domestic position that only jumps into their domestic market when it has a favorable wind.
Well, I went back to the drawing board and thought “why is the home country bias a bad thing?” Well, see the aforementioned overinvestment: if you’re working domestically and living domestically and investing most-to-all of your capital domestically, you are very screwed if the domestic economy suffers from a downturn. Job loss, inflation, and loss of capital all hitting at once is a bad bad not good thing! We can’t save your job or fight inflation, but what if Novatero could protect your domestic investment from a market downturn?
Our thought was this: 90% of the drops in markets typically happen during 10% of the trading days. These 10% of days are typically the most-volatile days in the market, so when volatility is up, markets are usually down. This is why the historical correlation between the S&P 500 and the CBOE Volatility Index (VIX) is around -0.77: when the S&P 500 is up, VIX is down and vice-versa. So what if we made a signal that goes long in the market when its favorable to do so, and goes in a volatility index when it looks like the market is getting shaky? We created a simple “double-switch” went between SPY, VIX, and no position based on a simple X-day past return and found it greatly increased both annualized return and volatility. This performance was maintained when VIX was replaced with a synthetic volatility index derived from S&P 500 daily prices, indicating that it is driven by volatility and not specifically the VIX. While the high return is great, the high volatility doesn’t really assure anyone except antacid salesfolk catering exclusively to investors. However, when this double-switch was paired with a long position the S&P 500 in a 70:30 split that rebalances quarterly, we saw the increase of annualized returns greatly outpace the increase of volatility. This 70:30 rebalancing split between the market and the double-switch was our Country-Oriented Volatility-Enhanced Strategy, or COVES.
With this working for the US market, we went on to test it for other countries. A total of 45 countries were represented by a representative index ETF, and COVES-XX were calculated for all of them (XX = 2-letter country code. US - United States, DE - Germany, and so on). The performance of the ETF, the double-switch, and COVES-XX for each country from 2016-June 2021 are in the table below:
Based on these results, the COVES-XX strategy provides a huge gain in terms of annualized returns that greatly outpaces the rise in volatility. Furthermore, COVES-XX does this with a smaller maximum drawdown in a large majority of markets, meaning that COVES-XX is eliminating downside volatility while preserving most of the upside volatility. COVES-XX represents a domestic strategy proof-of-concept that can improve investment return while greatly mitigating downside risk.
The Proposal - Bringing COVES to life via DeFi
So, what’s the catch? Why hasn’t something so simple yet so powerful been implemented and/or productized to all hell? I addressed this in the paper, but there’s a couple of major reasons for this. Transaction costs would take a piece out of these returns, but the main one is that a synthetic volatility index is impossible to invest in. Just like VIX, an index that represents volatility doesn’t have a root equity(ies) in the market, since it’s a measure of uncertainty. The best that VIX can do are derivatives and ETNs based on these derivatives; they provide some exposure to the core root of VIX but the inherent nature of derivatives and ETNs that carry them can overpower the VIX signal in terms of returns, especially the decay effect. The synthetic volatility indexes we create in the generation of the double-switch and COVES suffer the same fate, so there’s no way to actually hold a position in the volatility side of the double-switch and COVES…as least not through traditional finance assets. Damn.
However, Decentralized Finance (DeFi) provides a potential pathway hitherto unavailable before recently. In particular, the field of synthetic tokens in DeFi is showing a lot of promise as a potentially novel investment approach that has been taking concepts and structures from traditional finance and shining them through the prism of the blockchain. Two projects in particular, UMA Project and Yam Finance, have been collaborating on a couple of novel synth tokens that unlock some of the potential of this pathway, known as Yam Synths. For example, uGAS acts akin to a futures contract, only instead of locking in the price of silver or livestock or o̶n̶i̶o̶n̶s̶ or corn, uGAS locks in the price of ETH transactions, allowing those who transact in ETH to hedge against rising transaction costs or speculate on the direction of transaction prices.
However, the really pertinent synth is uSTONKS. Each uSTONKS 3-month token starts by compiling the top ten most-discussed stocks on r/wallstreetbets into an equally-weighted synthetic index. The token then tracks the daily performance of the ten stocks over the three month period, and once the period is over the worth of the token is a reflection of the growth or loss of the synthetic uSTONKS index. In terms of concept it is similar to investing in an index ETF for three months: if the index gains 10% after that time and you sell, you’ve essentially made the same return as a uSTONKS token that sees a 10% growth over its length. The big difference is that uSTONKS is wholly based on a synthetically-constructed index. No traditional index measures a bucket of r/WSB stonks, but uSTONKS creates the underlying index, provides access to pricing data of the index, is backed by tech that verifies the accuracy of the data and index, and allows the public to buy or mint tokens for uSTONKS for investors to hold or trade. The methodology is very similar to traditional index investing, it’s just the underlying technology that’s different.
Well, mostly. Due to the technology, synth tokens can be used to create indexes that aren’t a collection of equities…like a volatility index…or a double-switch signal that oscillates between two synthetic indexes…or a 70:30 split between an synthetic index of equities and the aforementioned double-switch. Synthetic tokens are a great vehicle for COVES because 1) they can be based on synthetic indexes, 2) they can be constructed to run for 3 months, essentially allowing for a “rebalance” from one token to the next, and 3) the underlying technology and transparency of the synthetic indexes can be verified by tech and by the community to validate the product.
This is why I’ve posted a proposal to UMA’s Discourse and will be in touch with some of my contacts at both UMA and Yam to see about making COVES a reality via their platforms. Feel free to hop over there and check out the details of the proposal!
An Example - Bringing COVES to Haiti
This brings us to our example. I briefly mentioned it in the paper, but I held up a country for a possible deployment of COVES in Haiti, a country in the Caribbean that I hold in esteem for two main reasons: it is the only state in history established by a successful slave revolt, and it is low-key producing bottle-for-bottle the best rum in the world. Haiti is the poorest country in the Western Hemisphere, suffering from a seemingly evergreen series of natural disasters and political chaos, as well as owning an economic engine that can’t seem to turn over. Providing a COVES-HT vehicle may not be directly beneficial at first to many Haitians who struggle to obtain basic necessities, but it could provide help for those involved in the Haitian economy and/or organizations working toward the economic betterment of Haiti.
The first hurdle in constructing a COVES-HT is Haiti’s lack of a public stock market, with the lack of any Haitian companies appearing on any global stock market close behind. This means that any market index used in COVES-HT will be bereft of any companies headquartered in Haiti. However, we can use foreign companies with a significant presence in Haiti as a reasonable approximation. The impact that Haiti has on, say, Coca-Cola’s bottom line is minimal, but the impact that Coca-Cola products have on Haiti’s economy is significantly larger. Finding a list of foreign companies with a significant presence in Haiti is hard to find, so I improvised a bit: I grabbed publicly-traded companies who have jobs available in Haiti according to Glassdoor. Very unscientific and tenuous I know, but in an actual attempt at this that wasn’t whipped up in a night to reinforce a point I would do much, much more due diligence than what is being displayed in this example. Daily pricing data was queried for 28 companies from 2016-June 2021, which was then shortened to 26 after two of the companies did not reach a minimum percent threshold of data over that period. The 26 companies can be found here.
The synthetic Haiti-adjacent stock market was cap-weighted, so there was no balancing beyond the small adjustments made when Upwork went public in October 2018. Applying the same methodology as the COVES SSRN paper, we obtained the following results:
Even with a less-than-stellar representation of a market we’re still seeing the magic of the double-switch and COVES shine through. While the synthetic Haiti market index returns roughly 5% annual, The double-switch sees a 6.4x increase on annualized return and only a 4.3x increase in volatility. COVES-HT sees a 3.4x increase in return and a 2.8x increase in volatility; COVES-HT isn’t quite the dynamo that we’re seeing with the 45 countries in the SSRN paper, but it’s still providing an almost 18% annual return and a 2.46x return on the initial investment in 5.5 years. One interesting divergence from the COVES paper is the max drawdowns: whereas max drawdowns are less deep for COVES-XX in the 45 ETFs, the max drawdown for COVES-HT is deeper than the synthetic market index. Is this due to the synthetic index, or is this a crack in the strategy itself? More research will need to be done to know for sure.
Overall, the promise of COVES is strong enough to overcome any technical hurdles along the way. I am greatly looking forward to pushing forward on this concept and am more than happy to discuss COVES and how it fits in with DeFi, investment portfolios, or beyond. Feel free to use the Contact page to reach out.