Sir O you haven't convinced me in any way.
Have I at least convinced you I'm not being a pr!ck and we can discuss these things calmly?
Counter these points.
Even if i did have backtesting results that remove the survivorship bias of using current weightings. Will the last 10 years be the same as the next 10? Good bet would be no?
Would they be perfectly aligned? Of course not but this is not the crux, the question is
will it be different enough. The more things change the more they stay the same. You are talking about a strategy that is based upon regression towards a mean. Market is overbought, put hedge in play, make money as market returns to mean. Market is oversold, remove hedge and allow to return to mean. Correct?
So is there a reason to suspect that the market swings from a percentage standpoint will differ
significantly from the past ten years? I
think - I'll even take an educated guess that the answer to that question is no.
That aside the weightings question is really a coin toss. Its just as likely that NCM will outperform BHP. In that case being weighted to the index will be a huge drag rather than benefit. You can in no weigh assume that being heaver into one stock will not benefit or degrade performance. But you can be sure that its skewed your risk.
TH I'm not sure if I'm going to express this correctly - here's a crack at it however, I'm trying to multi-task when writing these responses to you and I only have a short period of time to write this before I have to do something else.
Your strategy is using the ASX20 (largely). You've said you'll use an index to hedge rather than hedging each stock. Fair enough, I get it. Buy one instrument rather than 20, cuts down on your costs and makes the strategy simpler and faster - all great and highly important characteristics to ensure your strategy makes money.
These 20 stocks account for an appreciable percentage of our entire market. Our market indicies works on an aggregate basis - which is what your hedge is working from. The individual stocks being as they are from a range of sectors will not move perfectly in lock-step all the time. Different sectors and stocks will have different periodicity and amplitude and differing correlation with each other.
Since you are not individually hedging the contents of the core portfolio, these individual swinging incidents are irrelevant because you cannot take advantage of them with your chosen hedge. Only the aggregate performance of the index will determine when you place your hedge. By selecting a fixed percentage of funds into each position, rather than a weighted one, you are introducing a bias into your strategy that does not exist in the aggregate hedge you are using. Just as I
"can in no way assume that being heavier into one stock will not benefit or degrade performance." You cannot assume that the bias you have introduced will have no effect and
may actually increase your risk and potentially degrade your return.
Therefore unless you have a crystal ball and ensure me that BHP will not buy Xstrata at the next top or NAB buy AMP or a Super Tax on WOW etc etc I'll pass on a coin toss and be happy to reduce portfolio risk. That's my thinking.
The hedging can be fine tuned to the portfolio with a few extra oppies.
I'm running out of time here TH - but as I said before, you're not trading these things individually - it's more like funds management portfolio, you may actually be increasing risk - but unless you test for it you'll never know.
Cheers
Sir O