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“Blue Horseshoe loves Anacott Steel”: Optimal Hedge Ratios for QMIT’s LBO models

Jan 2024 -- Weichuan Deng, Oleg Kolesnikov, Amit Sardar & Milind Sharma

Recall “Blue Horseshoe loves Anacott Steel”?

Gordon Gekko & Bud Fox sure could have benefited from QMIT’s LBO strategies to stay out of jail. Indeed, in the age of AI, Gekko could have profitably deployed our Quantamental ML-enhanced trading signals to more than TRIPLE $ in 5y LIVE with our Sizzling LBOs (leveraged buyout) model for a gain of ~+268%. Or Gekko could have obtained equivalent exposure via structured notes/ swaps (with bespoke features such as principal protection). QMIT’s Sizzling LBOs strategy has more than TRIPLED in 5y LIVE to deliver +268% (30.56% ann) vs +170% (22% ann) on a fully hedged zero-beta basis with 1.74 Sharpe & 2.9 Sortino net of commissions, rebates etc. All performance numbers herein are subject to the disclaimers in the tab above:

In the dynamic world of finance, Leveraged Buyouts (LBOs) have been a particularly lucrative strategy, going back to the '80s with the pioneering firm of KKR & the pivotal LBO of RJR Nabisco as chronicled in the Barbarians at the Gate. They have the potential to unlock significant value from underperforming or undervalued companies. An LBO involves acquiring a company but with a significant amount of borrowed money (leverage) to meet the cost of acquisition. The expectation is that the subsequent improvements in performance and strategic restructuring will yield returns that outweigh the interest expense and provide substantial profits upon exit, typically through a sale or IPO. Leverage can either magnify returns or once the cycle turns, the debt burden can often bankrupt the underlying businesses while the PE partners extract rich dividends for themselves while rank & file employees get laid off. While the private equity industry & the corporate raiders (as epitomized by Michael Douglas in the iconic movie Wall Street) have done well for itself with carried interest, one must ask - where are the customers yachts? That remains unclear, after one is done with the long lock ups, lack of MTM/ transparency, layers of fees, “volatility laundering” & other accounting shenanigans. QMIT’s LBO strategy is a LIQUID PROXY FOR PE style returns without the PE shenanigans. Daily MTM & liquidity. Fully transparent No lock ups. No Gates. No shenanigans.

Table 1: LBO Top 100 Model Performance over 24 Years

Within the span of a 24-year history (2000-2023), the LBO Model from QMIT has shown remarkable performance. There are no down years against the Russell 2000 Value benchmark hedge. When we looked at the cum buyout stats around the time of launch in 2019 - of about 1250 unique cum predictions made, 541 had either been bought out or were in play which left ~700 predictions still open, consistent with the historical success rate of 41%.

Over the past 5 years of LIVE publication (& trading by clients), our QMIT LBO Top100 model has been harnessing this strategy within the public markets. The model has significantly outperformed the Russell 2000 Value Index (R2000V) over 24 years since Jan 2000. 2023 was no exception, as the base LBO Top100 model saw an impressive +40% gain, eclipsing the R2000V by +28.13% when hedged with the IWN ETF. This performance has contributed to a five-year cumulative return of +195% essentially TRIPLING net of tcost. But it's in the Sizzling LBOs model where we see even more exhilarating results—a +268% return. The QMIT Top 100 model is meticulously curated, encompassing an equal-weighted portfolio of the top ML predictions for LBO targets, rebalanced weekly. As an actionable trading signal based on liquid U.S. stocks ripe for LBO speculation it can be used both for managing event risk on the short side as well as for speculation on the long side. Interestingly, the impressive returns come from anticipating the activist catalysts that we’ve datamined history for. In other words, the strategy is not solely dependent on the buyout premium & outperforms regardless of the actual number of candidates that get bought out even though we’ve seen ~41% of predictions result in acquisition offers. In fact, when we last looked at it in 2019, the buyout names (usually around ~20% premium) drive only (1/3) of the total gains LTD with the remaining (2/3) coming from rumors, buybacks, dividend hikes or other favorable catalysts which propel the stock. This feature along with the cashflow support is why the LBO-IWN signal delivers in Bear markets like the Nasdaq crash & 2008. Post-crash it’s like a coiled spring which is why we saw the extraordinary outperformance in Sept 2002-03, 2009 & post Covid in 2020.

Our approach doesn't stop with the traditional LBO framework. We've introduced hedged versions of the QMIT LBO Top 100 model, which consider transaction costs and short rebates, adapting to the real-world challenges of weekly rebalancing. Whether it's a full 100% Hedge Ratio or dialed back to 85% or 70%, these models provide tailored exposure based on investor risk appetite. In the study below we consider the optimal Hedge ratio.

The Sizzling LBOs model is where we turn up the heat. By refining the Top 100 to an elite top 35, we apply even more stringent criteria to filter out only those stocks that not only meet the LBO potential but also pass our Sizzling Seven checks—averting the so-called 'falling knives' & earnings torpedoes. These stocks are further vetted for their feasibility in LBO financing from a broad universe of around 2,500 major U.S. stocks. The result is a model that's ripe for idea generation, long-side speculation, or event risk hedging, all while maintaining the flexibility to be used in a hedged format against the Russell 2000 Value ETF for “sharper” risk-adjusted returns.

2023's robust performance of the Top 100 Longs, with a rise of 40.03% and a hedged increase of 28.13% YTD, is a testament to the model's strength. The consistency is evident as the model notched up 15.60% hedged in 2022, marking its 24th year of outshining the index. The Sizzling LBOs, with their higher-octane strategy, didn't just follow suit—they led the charge, tripling in value and showcasing an annual compound growth rate of 30.56% with a Sortino ratio of 1.37. What stands out in our live 5-year track record is the performance of the fully hedged LBO Top 100 (HR 100%) against IWN, which yielded an annual return of 16.28% with a Sortino ratio of 2.63, significantly outperforming the long-term historical average. The out-sample robustness indicates that our model was not merely datamined for rosy in-sample performance.

Even after major financial upheavals, like the Global Financial Crisis in 2009 and the Covid downturn, our models have not just recovered—they have soared. The Sizzling LBOs model, for instance, more than tripled from the Covid lows.

Our analysis over both 5-year and 24-year periods underlines a critical insight: while high cumulative returns can be alluring, they often come hand-in-hand with heightened risk. It's here that an optimized hedge ratio becomes key towards maximizing the risk adjusted outcome. In the end, our study of the Optimal Hedge Ratios for QMIT’s LBO models over these periods is more than an academic exercise—it's a roadmap for investors looking to navigate the complexities of market dynamics with a robust, data-driven compass.


Figure 1 shows the Value-Added Monthly Index (VAMI), which measures the performance of an investment over 5 years, starting with a base value (typically 100) at a starting date. The Sizzling LBOs, which represent a more aggressive strategy by selecting the top-performing stocks from the LBO predictions, have shown the highest growth from 2019 onwards. The strategy has seen significant upward trends and has the highest VAMI, reaching 367.8%. Both the LBO100 and Sizzling LBO strategies have hedged (HR 100) and unhedged (HR 0) versions. The hedged versions underperform compared to their unhedged counterparts, which is expected since hedging typically reduces volatility and potential maximum returns in exchange for lower risk. Both the LBO100 and its hedged version are outperforming the IWN (Russell 2000 Value ETF), which is used as a benchmark. This suggests that the LBO strategies provide pure idiosyncratic alpha even after hedging out the Fama French size & style factors as per the IWN hedge.

Figure 2: Annual returns for Sizzling LBOs Hedged, Sizzling LBOs, Benchmark (IWN) & SPY -- 2019 to 2023

Figure 3: 5-Year cum returns

In Figure 3, we present the cumulative returns of LBO 100 and Sizzling LBO portfolios against the benchmark index IWN (Russell 2000 Value). These are adjusted by hedge ratios (HR) of 100%, 85%, and 70%. A hedge ratio of 0% indicates the total return, without any hedging influence i.e., Long Only whereas a hedge ratio of 100% means fully $-neutral.

Return_Hedged = (Long − HR × Benchmark)

The Sizzling LBO variant, unadjusted for hedging, concluded the period with the highest cumulative return of 268%. However, it's also with higher volatility when compared to the hedged variants. As demonstrated in the corresponding statistics table, the annualized returns for both the LBO 100 and Sizzling LBOs significantly outperform their hedged counterparts. However, they do incur greater volatility - 31.32% for LBO 100 and 33.20% for Sizzling LBO compared to the more modest vol seen in the hedged strategies (9.88% for LBO 100 (HR 100) and 12.82% for Sizzling LBO (HR 100)).

Table 2:  LBO TOP 100 VS SIZZLING LBO FLAVORS Statistics

The Sharpe ratio favors the hedged returns over the non-hedged LBO 100 or Sizzling LBOs. Within the 5-year dataset, a hedge ratio of 100% was optimal in terms of maximizing the Sharpe ratio for both LBO 100 and Sizzling LBOs. This conclusion is similar to the Sortino ratio, which also supports a 100% hedge ratio, with values of 2.63 for LBO 100 and 2.85 for Sizzling LBOs. Max drawdown is quite high for unhedged Long Only flavors but in the same ballpark as that of the IWN index ETF. These are significantly higher risk than the hedged drawdowns which for obvious reasons decline from 50% down to 13.24% for HR100 in the LBO 100.

The Sizzling LBOs strategy, with its higher-risk, higher-return profile, has demonstrated the ability to significantly outperform both the LBO100 strategy and traditional market indices. The hedged versions of the strategies have provided more stability and have shielded against downside risks, as seen in the negative market year of 2022. These results suggest that investors who are willing to accept higher volatility for the chance of higher returns would have been well-served by the Sizzling LBOs strategy. Meanwhile, those looking for more stable returns, possibly as part of a diversified portfolio, might find the hedged LBO strategies more appealing.

In conclusion, the data from both graphs indicate that QMIT's strategies, both the LBO Top 100 and the Sizzling LBOs, have been successful in delivering robust returns over the observed period, outperforming traditional market benchmarks. The Sizzling LBOs, despite their higher volatility, have offered substantial growth potential, while the hedged LBO strategies have provided a more consistent return profile.


For the 24-year dataset, we observe a pattern similar to the 5 years. The LBO 100 strategy, without hedging, achieves remarkable cumulative returns of 11,918%, and the hedged returns stand at 4,218% and 3088% for HRs of 100% and 85%, respectively (as shown in Figure 4).

Figure 4

Although the LBO 100 gets higher cumulative returns, it’s much lower in risk adjusted terms hence the desire to find the Optimal Hedge Ratio toward maximizing the risk adjusted outcome. The 24-year statistics reveal an annualized volatility of 25.58 for LBO 100, which is considerably higher than the hedged alternatives. The Sharpe ratios further elucidate this point, with the highest Sharpe ratio of 1.7 occurring at a hedge ratio of 85%, surpassing even the 100% hedge ratio.

In order to solve for the optimal hedge ratio which maximizes the Sharpe ratio of the hedged strategy let’s consider the objective function:

The resulting optimal HR* = 91% for 24y which includes the LIVE 5Y. If were to only consider the LIVE 5Y trailing ex post one can see that the optimal HR would have been 100% per above. It’s clear from this analysis that if one were to look at the in-sample 19Y vs the LIVE 5Y trailing ex post the HR* is quite consistent and around 90%. This is also evident by the Sortino ratios, which peak at 2.69 for LBO 100 (HR = 85). However, max drawdowns are somewhat more pronounced for LBO 100 (HR = 85) than for LBO 100 (HR = 100), though both are significantly lower than the unadjusted LBO 100 and the benchmark IWN (R2000 Value). It’s noteworthy that even without any portfolio construction or risk optimization, merely hedging out the Fama French size & style factors results in vol reduction by 2/3 from 25.6% down to 8.26%. There’s enough idiosyncratic alpha in the signal to power a 2.6 Sortino after the Russell 2000 Value hedge.

Table 3:  LBO TOP 100 Hedge Ratios

The analysis of both 5-year and 24-year periods suggests that while higher cumulative returns are dominant, they come with an increase in risk, as indicated by higher volatility and max drawdowns. An optimized hedge ratio can potentially offer a more balanced risk-return profile, enhancing the Sharpe and Sortino ratios, and thereby suggesting a more reliable investment strategy over the long term.

All performance numbers herein are subject to the disclaimers in the tab above:  

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