## Executive summary:

- You can boost your potential return and lower your risk by replacing a Treasury bond ETF with a hedged portfolio, such as the one shown below.
- This portfolio has a negative hedging cost, meaning you would effectively be getting paid to hedge.
- This portfolio will limit an investor's downside risk to a drawdown of less than 7% in a worst case scenario.

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## Why You Should Consider Replacing This ETF

The iShares 20+ Treasury Bond ETF (NYSEARCA:TLT) has nearly $3 billion in assets, but a look at its historical returns could lead one to question why so many investors own it. Shareholders in the ETF have been subjected to the risk of steep declines, in return for fairly modest returns. In the average six month period over the last ten years, TLT has generated a total return of about 3%, but at the risk of double digit declines. Last year, for example, TLT's share price dropped nearly 18% from the beginning of May to late August.

If you own TLT, and are satisfied with that sort of risk versus reward, then you need not read any further. But if you're willing to consider a different approach that can give you a potential return greater than 3% over six months, without risking double digit declines, read on.

## When Stocks Can Be Safer Than A Treasury Bond ETF

It may seem counterintuitive that you can be exposed to less risk by holding equities than by holding a Treasury bond ETF, but that can be the case when you own those stocks within a hedged portfolio. Let's review some of the basics of hedged portfolios, and then see how we can go about creating one that can offer a higher potential return with lower risk than TLT for an investor with $100,000 to invest.

## 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. For this example, we'll assume that our investor doesn't want to risk more than a 7% drawdown in the worst case scenario, so his threshold here will be 7%.

We'll also assume, to be conservative, that he wants to minimize his hedging cost, so we'll seek primarily to minimize his hedging cost and secondarily to maximize his potential return given these constraints. Our goal here isn't to get the highest potential return in absolute terms, but get one that's higher than the historical returns on TLT have been and to do so while being exposed to less downside risk.

## 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 and minimize hedging cost 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.**One place to search for these securities is among the top holdings of a billionaire investor, as we did with Carl Icahn's holding company in a recent article ("Investing Alongside Carl Icahn While Limiting Your Downside Risk"). 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. In general, though, 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-7% 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.**Sorting The Securities By Hedging Cost**. Because we're seeking primarily to minimize hedging cost, we add this step here. We sort these securities inversely by hedging cost, so we rank the ones with the lowest hedging costs (as percentages of position) first. We'll only consider the ones from the top of this list (the ones with the lowest hedging costs) for the next step.**Buying the securities with the highest net expected returns.**In order to determine which securities these are, out of the truncated list above, 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.**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. Since we're working with a $100,000 portfolio in this example, stocks such as Priceline.com (NASDAQ:PCLN), trading at more than $1000 per share, wouldn't work for us. 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 to replace TLT using general process described above, facilitated by the automated portfolio construction tool at Portfolio Armor. The first field, "Tickers," we'll leave blank, so the tool will start with its own universe of about 3,000 securities. In the second field, we'll enter the dollar amount of our investor's portfolio (100000), and in the third field, the maximum decline he's willing to risk in percentage terms (7). We'll set the strategy to "Minimize Hedging Cost."

A couple minutes after clicking the "Create" button, we were presented with the following hedged portfolio. The data here is as of Friday's close (results may, of course, differ, depending on prevailing market conditions):

## Why These Particular Securities?

DexCom, Inc. (NASDAQ:DXCM), Facebook (NASDAQ:FB), Cheniere Energy (NYSEMKT:LNG), and Solar City (NASDAQ:SCTY) don't appear to have much in common, at first glance. 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 4.46% to 5.34%. What these securities have in common is that, of the thousands of hedgeable securities trading in the US, as of Friday's close, they could be hedged in ways to generate the highest net expected returns for an investor who was only willing to risk a 7% decline, and who was seeking primarily to minimize his hedging cost.

## 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, DexCom, Inc. :

As you can see in the image above, DXCM is hedged with an optimal collar with its cap set at 4% (the other three securities are hedged as cash substitutes, with optimal collars with their caps set at 1%). Using an analysis of historical returns as well as option market sentiment, the tool calculated an estimated return of 4% for DXCM over the next six months. That's why 4% 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 DexCom if it appreciates beyond 4% over the next six months.[i] As you can see at the bottom of the screen capture, the net cost of this optimal collar, as a percentage of position value, was negative, meaning the investor would effectively be getting paid to hedge in this case.[ii]

## 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 6.86%.
- 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 collected for hedging these securities, which was 3.11%[iii].
- 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 4.74%[iv]

## Worthy Of Consideration For Risk-Averse Investors

The three scenarios above give an idea of the range of possible outcomes here. Better returns than TLT has generated over the average six month period over the last ten years are likely in a sideways-to-positive market, and the worst case scenario is a decline of 6.86%, which is less than half the decline TLT investors had to stomach last year. Given the potential return and lower the risk of this approach, investors currently holding TLT ought to consider it as an alternative.

[i] This hedge actually expires in 7 months, but the expected return is based on the assumption that an investor will hold the position for six months, until it is called away or until shortly before the hedges expires, 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 would likely have collected more than $100 on opening this hedge.

[iii] "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.

[iv] 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 4.74% over six months.

**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.

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