Which way to jump?
Recent analyst predictions for the S&P500 (NYSEARCA:SPY) in the coming year seem to be centered around the 1500-1600 range, with a clear consensus that the issues around the fiscal cliff will be put behind us, and investors will return to the market to capture the upside of an economy bolstered by QE liquidity injections and trading into a recovering global environment. Balancing this we see significant downside risk, equities relatively expensive in historical and global perspectives, and a fourth year of market gains supported by increasing margin debt. A faltering of the economic recovery could result in a rush to the exits, and a 20 - 30% drop which would wind the clock back to 2010. Many ask the question whether to sit on the sidelines until the fundamental outlook is more secure, or jump in boots and all.
To many the answer is to rely on asset allocation approaches, with significant positions in traditionally non correlated exposures such as USD long bonds (NYSEARCA:TLT), and precious metals, represented here by two popular ETFs (GLD, SLV). However, the impact of QE seems to have weakened the anti correlation of GLD and SPY, while the volatility of the SLV price generates a boom-bust risk profile. The chart below shows both the weakened diversification of GLD and erratic nature of SLV prices.
Source - Yahoo Finance
US long bond yields have been suppressed to generate negative returns on an inflation adjusted basis.
Much of the issue with a simple asset allocation approach with allocations to cash and bonds stems from the current low yield environment. While the Fed maintains an easing stance, which we can certainly factor into the medium term outlook, this will continue to be a challenge.
One approach to investigate into 2013 is to adjust asset allocations from traditional low risk areas such as cash and bonds into assets that have diversifying characteristics but higher yields - seeking this less correlated yield with the lowest incremental risk will be a key theme for me in the months to come.
Risk management in this space now faces significant short term uncertainty, and the potential for significant asset erosion correlated with a potential equity correction. This underlines the need to consider alternative approaches to downside hedging.
Hedging through put options
It has been suggested that one simple way to maintain exposure in an uncertain market environment with strong portfolio diversification is by purchasing some downside insurance via hedging through put options. A simple strategy would be to use the dividend yields of the stock to purchase a 12 month put option at the money to hedge a portion of the downside risk. This of course comes at a cost, so to test the effectiveness of such a strategy I ran a simulation.
Jan 2014 142 SPY puts are currently around $12, which is a premium of about 8.5% annualized. The SPY ttm yield is 2% which means that we could use dividends to fund a hedge in the range of 20% after adjusting for future earnings and netting off tax on dividends.
I used a 22% hedge on a notional SPY portfolio of $100,000, and assumed that the average put costs would be consistent at the 8.5% annualized level.
In this way, the downside risk of a drop in the index is hedged by a put option which gives the buyer the right to sell the stock at the strike price at or before the option expiry date, so if the index drops below 142, the ETF can be sold at 142. The strategy would then be to reinvest the profit at the new price.
If the index finishes the year above 142, the cost is 1.87% of the starting value. The outcome as represented below shows that over a 25 year period, the hedge would have generated a recovery of only 66% of the costs, overall resulting in a 12% lower return than simply remaining invested over the period.
|Hedge cost Return|
|66.1%||hedge efficiency||1.87%||hedge cost|
To further test the impact of the selected time series, I ran the analysis over 10, 15 and 20 year timeframes. In each case the hedge generated little or no value, with the best outcome over the last 10 years, just capturing the 2 largest market drops in the 25 year period - in this case the outcome overall is breakeven, with the hedge generating 70% more recoveries than costs, but the compounding effect of remaining fully invested on the unhedged portfolio fully compensating.
This analysis demonstrates that the options market is pretty efficient over time - the market prices in the volatility with a time and risk premium that overrides the positive hedging benefits. For such a strategy to be effective over time, the cost would need to be managed in a tax effective manner. The strategy here would be to use bullish options strategies to invest in the underlying market, generating gains which can be used to defray the costs of the put - a hard task with the hedge efficiency as low as 66% of the costs.
The bottom line
Hedging via replicating puts is not a "magic bullet" to managing market uncertainty, being able to time the market is the all elusive solution. Absent this, the tried and tested approaches of picking the right investments, in a carefully considered allocation, and mixing patience with the discipline to enter and exit positions in response to market movements that generate value discontinuity seem to hold water.
However, it is also important to also retain the agility to flex the tactics employed to stick to your chosen strategy, thinking why something has worked in the past and adjusting to today's market.
Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.