**Executive summary:**

- One can invest in top holdings of a highly rated mutual fund while strictly limiting one's downside risk with 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 15%.
- Investors with lower risk tolerances can use a similar process, though their potential returns may 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 maximize his potential return while limiting his losses, in the worst case scenario, to a drawdown of no more than 20%. In this post, we'll consider the case of an investor with the same size portfolio, but with a somewhat lower risk tolerance -- a desire to limit his losses to a drawdown of no more than 15%. Also, in this post, we'll look at a new source of ideas for a hedged portfolio -- the top holdings of a highly rated mutual fund.

**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.

**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:

- Find securities with high expected returns.
- Find securities that are relatively inexpensive to hedge.
- 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).
- 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.**In our previous article, we mentioned Seeking Alpha Pro as one source of these securities. Another source is the top holdings of a leading mutual fund. One such fund is the Delaware Pooled Large Cap Growth Fund (DPLGX), a large cap growth fund, which is 5-star rated by Morningstar, Lipper, and Standard & Poor's. Since this fund has a history of high returns, it's not unreasonable to assume its top holdings might have high expected returns. The current top 10 holdings of this fund are EOG Resources (EOG), Visa Inc. (V), MasterCard Class A (MA), Celgene Corporation (CELG), Crown Castle International (CCI), Adobe Systems Inc. (ADBE), Qualcomm, Inc. (QCOM), Priceline.com (PCLN), Walgreen Company (WAG), Liberty Interactive Corp (LINTA). To quantify expected returns for these securities, you can, for example, use analyst's price targets for them and then 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 inexpensive ways to hedge these securities**. First, you'll need to determine whether each of these top holdings are hedgeable. Then, whatever hedging method you use, for this example, you'd want to make sure that each security is hedged against a greater-than-15% 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 going out approximately six months). And you'll need to calculate your cost of hedging as a percentage of position value.**Buying the securities with the highest net expected returns.**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. If any of the top holdings of this mutual fund have negative net expected returns (that is, the cost of hedging them is more than their expected return over the same time frame), you'll want to exclude them.**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 , 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.

**An Automated Approach**

Here we'll show an example of creating a hedged portfolio using the general process described above, facilitated by the automated portfolio construction tool at Portfolio Armor. In the first step, we'll enter the ticker symbols of the top ten holdings of the Delaware Pooled Large Cap Growth Fund, the dollar amount of our investor's portfolio (1000000), and the maximum decline he's willing to risk in percentage terms (15), as in the screen capture below.

In the second step, we're given the option of entering our own expected returns for each of the securities. In this example, we will leave these blank, and use the tool's own expected return calculations.

A few minutes after clicking the "create" button above, we were presented with the hedged portfolio below. The data in it is as of Friday's close.

**Each Security Is Hedged**

Note that in the portfolio above, each of the underlying securities is hedged (Qualcomm is hedged with an optimal put; the rest of the positions are hedged with an optimal collar). 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. The tool added Cheniere Energy (LNG) as a cash substitute; the other seven securities in the portfolio come from the Delaware Pooled Large Cap Growth Fund's top 10 holdings -- they were the ones with the highest net expected returns out of those top ten. Here's a closer look at the hedge for one of those top holdings, Visa:

As you can see in the image above, V is hedged with an optimal collar with its cap set at 11.01%. Using an analysis of historical returns as well as option market sentiment, the tool calculated an estimated return of 11.01% for LNG over the next six months. That's why 11.01% 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 V if it appreciates beyond 11.01% 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]

**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 15% decline, features a potential return of 10.33% over six months. That potential return is what the portfolio will return if each of its underlying securities achieves its expected 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 14.83%.

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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 $80 to open this collar.

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