## Executive summary:

- You can invest in a top finance blogger's picks while strictly limiting your downside risk 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 is designed for an investor who is willing to risk a maximum decline of up to 10%.
- Investors with higher or lower risk tolerances can use a similar process, though their potential returns may differ.

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## Investing Alongside The Best Buy & Hold Blogger

In a recent article, we considered one source of ideas for a hedged portfolio: the top holdings of billionaire investor Carl Icahn's Icahn Enterprises, L.P. (NASDAQ:IEP). In this one, we'll consider another source of ideas: the buy list of a top finance blogger, Eddy Elfenbein of Crossing Wall Street.

CNN Money rated Eddy Elfenbein as the best buy and hold blogger. Every December, Elfenbein posts his buy list for the year to come, and for the past 7 years in a row, his buy list has beaten the S&P 500.

## Being Prepared For Bear Markets

Although Elfenbein has a market-beating track record, he is careful to warn investors of the risks inherent in stock investing. It's worth quoting part of the warning he offers investors on his blog:

Be prepared for bear markets. A lousy market can strike at any time without warning. All stocks go down. [...] Stocks are volatile by nature. That's the price you pay for superior returns. [...] If you can't bear to see your portfolio drop by 50%, do not invest in the stock market.

Elfenbein's warning should be heeded by unhedged investors, but investors who are willing to hedge can invest in the stock market while limiting how much their portfolios will drop in the event of a bear market. In this post, we'll go over how an investor with $500,000 to invest could construct a hedged portfolio using names from Eddy Elfenbein's buy list while limiting his risk to a maximum drawdown of 10% in the worst case scenario.

Let's review some of the basics of hedged portfolios and then see how we can create one using Eddy Elfenbein's buy list as a starting point.

## 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. So, we should expect that an investor who is only willing to risk a 10% decline will likely have a lower potential return than one who is willing to risk, say, a 20% decline.

## 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 a bear market strikes without warning -- your downside will be strictly limited.

## How to Implement This Approach

**Finding securities with high expected returns.**Eddy Elfenbein's buy list has beaten the market 7 years running, so it would seem like a good place to look for stocks with high expected returns. However, Elfenbein does not post his estimates of how each stock will perform. If you want to narrow his list of 20 stocks a bit, you could, for example, start with the ones that are up the most year-to-date. As of Monday, those were Stryker (NYSE:SYK), DirecTV (NASDAQ:DTV), CR Bard (NYSE:BCR), and Express Scripts (NASDAQ:ESRX). Or, you can start with the whole list, as we will do below. In either case, 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 the names on the buy list 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-10% decline over the time frame covered by your expected return calculations (our method attempts to find optimal static hedges using collars as well as 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 Elfenbein's holdings 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 $500,000 portfolio, but for an investor with, say, a $100,000 portfolio, stocks such as Priceline.com (NASDAQ: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.

## 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. As we noted above, you can start with just a handful of stocks on the buy list, if you want. That way, you'd have fewer transaction costs. But, for illustration purposes, we'll start with the whole list here. In the first step, we'll enter the 20 ticker symbols of the stocks on Elfenbein's buy list, the dollar amount of our investor's portfolio (500000), and the maximum decline he's willing to risk in percentage terms (10). We'll keep the strategy set to the default, "Maximize Potential Return".

Note that, next to the "Tickers" field above is the word "optional" in parentheses. You can use this tool without entering any ticker symbols, in which case the site will build your portfolio using the handful of securities in its universe of 3,000 names that have the highest expected returns net of hedging costs, given your risk tolerance.

In the second step, we're given the option of entering our own expected returns for each of the securities. For 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 Monday's close.

## Why These Particular Securities?

The tool ended up including most of Elfenbein's buy list. The tool added Facebook (NASDAQ:FB) to the portfolio as a cash substitute, hedged with an optimal collar with its cap set at 1%. This minimized leftover cash from rounding down dollar amounts to round lots of shares, and it reduced the overall hedging cost of the portfolio.

## Each Security Is Hedged

Note that in the portfolio above, each of the underlying securities is hedged. BCR is hedged with an optimal put, since it had a higher net expected return hedged that way than with an optimal collar. The other names are hedged with optimal collars. Here's a closer look at the hedge for the first position, AFLAC (NYSE:AFL):

As you can see in the image above, AFL is hedged with an optimal collar with its cap set at 4.06%. Using an analysis of historical returns as well as option market sentiment, the tool calculated an estimated return of 4.06% for AFL over the next six months. That's why 4.06% 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 AFL if it appreciates beyond 4.06% over the next several 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.[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 have effectively gotten paid (a little more than $2,900) to hedge this portfolio.

## Lower Risk, Lower Potential Return

In our recent article about investing alongside Carl Icahn, that hedged portfolio, for an investor willing to risk a 16% decline, featured a potential return of 16.79% over six months. This one, for an investor who is only willing to risk a 10% decline, features a lower potential return, as you might expect: 6.87% 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 a decline of 9.81%.

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[i] This hedge actually expires in less than six months; as you can see in the screen capture of the portfolio, the expected return for AFL has been adjusted downward accordingly, 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 may have collected more than $60 to open this collar.

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