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Executive summary:

  • An investor can protect himself against a severe correction while maximizing his potential return by using a hedged portfolio, such as the one shown below.
  • This portfolio has a negative hedging cost, meaning the investor would effectively be getting paid to hedge.
  • This portfolio is designed for an investor who is willing to risk a maximum decline of up to 20%.
  • Investors with lower risk tolerances can use a similar process, though their potential returns would be lower.

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In a recent article, we considered the case of an investor with $1 million to invest, who wanted to get better-than-cash returns but had a very low risk tolerance, and in addition, was sensitive to hedging costs. In that example, the maximum drawdown the investor was willing to risk was 5%. The portfolio in that article offered him a potential return of 3.71% over six months -- nearly 15 times the return he could expect from a money market, but nevertheless, a fairly modest potential return in absolute terms. This time, we'll consider the case of an investor with the same amount of money to invest but a greater risk tolerance, one who is willing to risk a drawdown of up to 20%.

Risk Tolerance, Hedging Cost, and Potential Return

All else equal, with a hedged portfolio, the greater an investor's risk tolerance -- the greater the maximum drawdown he is willing to risk (his "threshold") -- the lower his hedging cost will be and the higher his potential return will be. An investor who is willing to risk a 20% drawdown is in good company. Several years ago, in one of his market commentaries, portfolio manager John Hussman had this to say about 20% drawdowns:

"An intolerable loss, in my view, is one that requires a heroic recovery simply to break even… a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally)."

Essentially, 20% is a large enough threshold that it can reduce the cost of hedging, but not so large that it precludes a recovery.

Constructing A Hedged Portfolio

In a previous article ("Rethinking Risk Management: A New Approach To Portfolio Construction"), we discussed a process investors could use to construct a hedged portfolio designed to maximize potential return while limiting risk. We'll recap that process here briefly, and then explain how you can implement it yourself. Finally, we'll present an example of a hedged portfolio that was constructed this way with an automated tool. The process, in broad strokes, is this:

  1. Find securities with high expected returns.
  2. Find securities that are relatively inexpensive to hedge.
  3. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high expected returns net of their hedging costs (or, ones with high net expected returns).
  4. Hedge them.

The potential benefits of this approach are twofold:

  • If you are successful at the first step (finding securities with high expected returns), and you hold a concentrated portfolio of them, your portfolio should generate decent returns over time.
  • If you are hedged, and your return estimates are completely wrong, on occasion -- or the market moves against you -- your downside will be strictly limited.

How to Implement This Approach

  • Finding securities with high expected returns. For this, you can use Seeking Alpha Pro, among other sources. Seeking Alpha articles often include price targets for long ideas, and you can convert these to percentage returns from current prices. But you'll need to use the same time frame for each of your expected return calculations to facilitate comparisons of expected returns, hedging costs, and net expected returns. Our method starts with calculations of six-month expected returns.
  • Finding securities that are relatively inexpensive to hedge. For this step, you'll need to find hedges for the securities with high expected returns, and then calculate the hedging cost as a percentage of position value for each security. Whatever hedging method you use, for this example, you'd want to make sure that each security is hedged against a greater-than-20% decline over the time frame covered by your expected return calculations. Our method attempts to find optimal static hedges using collars as well as married puts.
  • Buying securities that score well on the first two criteria. In order to determine which securities these are, you may need to first adjust your expected return calculations by the time frame of your hedges. For example, although our method initially calculates six-month expected returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our expected return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you'll need to subtract the hedging costs you calculated in the previous step from the expected returns you calculated for each position, and sort the securities by their expected returns net of hedging costs, or net expected returns. The securities that come to the top of that sort are the ones you'll want to consider for your portfolio.
  • Fine-tuning portfolio construction. You'll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs, so if you're going to include a handful of securities from the sort in the previous step and you have a relatively small portfolio, you'll need to take into account the share prices of the securities. That won't be an issue in our example here of a $1 million portfolio, but for an investor with, say, a $100,000 portfolio, stocks such as Priceline.com (PCLN), trading at more than $1000 per share, would be problematic. Another fine-tuning step is to minimize cash that's leftover after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won't need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method searches for what we call a "cash substitute": that's a security collared with 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. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step.

Example Portfolio

Here is an example of a hedged portfolio created using the general process described above by the automated portfolio construction tool at Portfolio Armor. This portfolio was generated as of Tuesday's close (results could differ at different times, depending on market conditions), and used as its inputs the parameters we mentioned for our hypothetical investor above: a $1 million portfolio, and a goal of maximizing potential return while limiting downside risk, in the worst-case scenario, to a drawdown of no more than 20%.

Each Security Is Hedged

Note that in the portfolio above, each of the underlying securities is hedged. Hedging each security according to the investor's risk tolerance obviates the need for broad diversification, and lets him concentrate his assets in a handful of securities with high expected returns net of their hedging costs. Here's a closer look at the hedge for one of these positions, Cheniere Energy (LNG):

As you can see in the image above, LNG is hedged with an optimal collar with its cap set at 22%. Using an analysis of historical returns as well as option market sentiment, the tool calculated an estimated return of 22% for LNG over the next six months. That's why 22% is used as the cap here: the idea is to capture the expected return while offsetting the cost of hedging by selling other investors the right to buy LNG if it appreciates beyond 22% over the next six months.[i] As you can see at the bottom of the screen capture, the net cost of this optimal collar was negative, meaning the investor would have been paid to open this hedge.[ii]

Why These Particular Securities?

In addition to LNG, Alliance Data Systems (ADS), Facebook (FB), Gilead Sciences (GILD), Sina Corporation (SINA), Under Armour (UA), and Yahoo (YHOO) were selected in the initial sort because, as of Tuesday's close, for an investor looking to hedge against greater-than-20% declines over the next several months, these securities had the highest net expected returns (since net expected returns depend in part on low hedging costs, this sort might look different for an investor only willing to risk a 10% decline, for example). YHOO appears twice in this portfolio: once hedged with an optimal collar with its cap set at its six-month expected return, and once hedged as a cash substitute, with an optimal collar with its cap set at 1%. Although these two positions include the same underlying security, the difference in the way they are hedged results in different hedging costs and different net expected returns.

Negative Hedging Cost

Although minimizing hedging cost was only the secondary goal here after maximizing potential return, note that, in this case, the total hedging cost for the portfolio was negative, meaning the investor would receive more income in total from selling the call legs of the collars on his positions than he spent buying the put legs.

Higher Risk, Higher Potential Return

As we noted above, in a previous article, a hedged portfolio for an investor willing to risk no more than a 5% decline featured a potential return of 3.71%. This hedged portfolio, for an investor willing to risk a 20% decline, features a potential return of 21.41%. That potential return is what the portfolio will return if each of its underlying securities achieves its expected return. Since it's more likely that some of the securities will fall short of their expected returns and some will exceed their expected returns, and since the collared securities have their upsides capped, the investor's actual return may trail his potential return. But in the worst-case scenario -- if every one of these securities went to zero before their hedges expired -- the investor's downside would be strictly limited to 19.8%.

Possibly More Protection Than Promised

In some cases, hedges such as the ones in the portfolio above can provide more protection than promised. For an example of that, see this post on hedging Tesla Motors' (TSLA) last fall.

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[i] This hedge actually expires in a little more than 7 months, but the expected returns are based on the assumption that an investor will hold his positions for six months, until they are called away or until shortly before their hedges expire, whichever comes first.

[ii] 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, an investor probably would have collected more than $200 to open this collar.

Source: How To Maximize Potential Return While Protecting Against A Severe Correction