Worried About A Market Meltdown? Consider This

by: David Pinsen

Another Week, Another Warning

As the cyclical bull market that started in March 2009 has ground on, it seems that every week we've had warnings about its imminent end. One of the common warnings last week, exemplified by the tweet below, was that the high levels of margin debt were a precursor to a market meltdown:

Margin debt at the NYSE is at an all-time high. Meaning global stock markets are susceptible to a severe set-back pic.twitter.com/DOSf6jOh5h

- Daniel D. Eckert (@Tiefseher) February 4, 2014

The Problem With Market Meltdown Warnings

The problem with these warnings isn't so much that they're often wrong: at some point -- perhaps soon -- they will be right. The problem is that there's an opportunity cost to having a constant bunker mentality: if you put most of your money in cash, you'll get miserly returns on that cash while missing out on most further equity market upside; if you pour money into an inverse ETF, such as the Direxion Daily Small Cap Bear 3x (NYSEARCA:TZA), you'll rack up losses while you wait.

Another Approach

Another approach is to stay invested but hedge. This can present its own challenges though:

  • Cost. Hedging, particularly if it's not done optimally, can be expensive.
  • Difficulty limiting losses to single-digit declines. This is related to the previous point about cost. Often the cost of protecting against, say, a greater-than-5% decline in a position will cost more than 5% of your position value, and so be impracticable.

A New Approach

In a recent article ("Rethinking Risk Management: A New Approach To Portfolio Construction"), I described a new approach ("hedged returns") that can obviate the problems mentioned above. Below, we'll look at an example of how a hedged returns portfolio could allow an investor to stay invested while limiting his downside risk to no more than 5% in the event of a major market meltdown.

Protecting A Million Dollar Nest Egg

Consider the case of an investor with $1 million in cash who is tired of getting money market returns of about 0.5% per year, but wary of investing in the stock market at current levels. He's willing to accept some downside risk, but not much -- the worst possible decline in the value of his account that he could tolerate is 5%. And on top of that, he's very frugal, so he doesn't want to pay much at all to hedge. Using Portfolio Armor's hedged portfolio construction tool, he'd skip the first field ("Tickers") if he didn't have any investment ideas in mind, and he'd enter "1000000" in the next field ("Dollar Amount Of Portfolio"), and "5" in the field after that ("Threshold", which refers to the largest decline he would be willing to risk).

As you can see in the image above, in the fourth field, our hypothetical investor would pick the "Minimize Hedging Cost" strategy, because he is sensitive to hedging cost. This strategy seeks to primarily to minimize hedging costs, and secondarily to maximize potential return. A couple minutes after clicking the "Create" button, he would have been presented with the following hedged portfolio, as of Friday's close (results may, of course, differ, depending on prevailing market conditions):

Each Security Is Hedged

Note that each of the above securities is hedged. Here is a closer look at the hedge for the first position, Biogen (NASDAQ:BIIB):

As you can see in the second image above, Biogen is hedged here with an optimal collar with its upside capped at 1% (its "cap") and its maximum downside limited to 5% (its "threshold"). We call a position hedged in this way a "cash substitute", because we use a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor's downside limited according to his specifications. All of the underlying securities in this portfolio, except one, the iShares Silver Trust ETF (NYSEARCA:SLV), are hedged in this manner. Also, as you can see the bottom of this image, the net cost of this collar is negative, meaning the investor would be getting paid to hedge BIIB in this case[i]. That's true of all of the hedged positions in this portfolio as well.

Why These Particular Securities?

In the previous screen capture of the hedged portfolio, in addition to Biogen and the iShares Silver Trust ETF, we have a handful of other securities that, at first glance, would seem to have little in common: Facebook (NASDAQ:FB), Google (NASDAQ:GOOG), Netflix (NASDAQ:NFLX), PriceLine.com (NASDAQ:PCLN), and United Continental (NYSE:UAL). But if you look at the furthest right column, "Net Expected Return" (i.e., expected return net of the cost of hedging), you'll notice that the figures for these positions cluster in a fairly tight range, from 3.22% to 4.16%. What these securities have in common is that, of the thousands of hedgeable securities trading in the US, as of Friday's close, these had the highest expected returns net of hedging costs for an investor who was only willing to risk a 5% decline, and who was seeking primarily to minimize his hedging cost.

Risk Versus Return

As you might expect, the larger a decline an investor is willing to risk, the higher the net expected returns he'll see for individual positions in his portfolio. In this hedged portfolio example, if each of these underlying securities went to zero before their hedges expired, our investor's portfolio wouldn't decline more than 4.99%, so his risk is very modest. Consequently, the potential six month return of his portfolio, at 3.71%, is also modest compared to a less tightly-hedged portfolio. But compared to cash, this potential return is quite generous. Consider that the average money market fund is yielding less than 0.5% per year, or 0.25% every six months. 3.71% is nearly 15 times as high. And in one scenario, the investor could earn that 3.71% return sooner than six months from now, freeing up his money to be reinvested in another hedged portfolio, perhaps one with a higher potential return.

Three Possible Scenarios

Let's consider three possible scenarios for the market in general, and for the underlying securities in this hedged portfolio in particular, over the next few months, and how each would affect our hypothetical investor's returns:

  • A major market meltdown, as bad as 2008, or even 1929. In the worst case, our investor's portfolio would be down 4.99%.
  • A sideways market. For this example, let's assume each of the underlying securities in our investor's portfolio goes sideways as well. Our investor's return would be close to the net income he got for hedging these securities, which was 2.42%[ii].
  • Another upward surge in the current bull market. What if the stock market goes on a tear in the next few weeks or months? In that case, it's possible that each of our investor's underlying securities would appreciate beyond their caps, meaning they would be called away. In that case, his return would be 3.71%[iii]

Worthy Of Consideration For Risk-Averse Investors

The three scenarios above give an idea of the range of possible outcomes here. Better-than-cash returns are likely in a sideways-to-positive market, and the worst case scenario is a decline of 4.99%. Given the range of possible outcomes, this approach may be worthy of consideration for risk-averse investors. Less risk-averse investors might consider a hedged portfolio with a larger threshold and a higher potential return.

[i] To be conservative, the net cost of the collar was calculated using the bid price of the calls and the ask price of the puts. In practice, an investor can often sell the calls for a higher price (some price between the bid and ask) and he can often buy the puts for less than the ask price (again, at some price between the bid and ask). So, in practice, the investor would likely have gotten paid more than $2,800 to open this collar.

[ii] "Close", because if the investor sells his underlying securities shortly before their hedges expire, to be prudent, he'd want to buy-to-close his short calls first, then sell his underlying securities, and then sell his puts. The cost of the calls, at that point, would be much less than the income he received for selling them in the first place, due to time decay, and it may or may not be offset fully by any residual income he gets from selling the puts shortly before expiration.

[iii] To be conservative, this potential return figure assumes that the investor will not be able to recoup any residual value for the put options he bought when he opened his collars. If he holds these positions for six months or until shortly before the hedges expire (whichever comes first), that assumption may be correct, as the time value of the hedges will have declined significantly. But if the investor's positions get called away after only a few weeks or months, he may be able to recoup some of the cost of his put options by selling them. In that case, his actual return could be higher than 3.71%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.