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Summary

  • You can hold a position in SolarCity 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 wants to maximize his potential return while limiting his downside risk to a drawdown of no more than 16%.
  • Investors with higher or lower risk tolerances can use a similar process, though their potential returns may be different.

After hitting a new high intraday on February 28th, shares of solar energy company SolarCity (NASDAQ:SCTY) had slid about 9% by Thursday, March 6th's close. The company had announced on Monday that it would have to restate its earnings going back to 2012, due to an error in the way it had accounted for its overhead expenses. SolarCity also pushed back the release of its Q4 2013 financials to March 18th. That was the second time the company had delayed the release of its Q4 numbers, which was originally scheduled for February 24th. After SolarCity's announcement on Monday, Levi & Korsinsky, LLP was one of several law firms that announced it would investigate whether the company had violated federal security laws.

Given SolarCity's big run-up over the last six months (the stock was up more than 170% over the last six months, as of Thursday's close), its current valuation (including a price/sales ratio more than 10x its industry's average over the last 12 months, per Fidelity's data) and the bit of uncertainty related to the company's earnings restatements, some SolarCity investors may want to add downside protection here. One way to do that would be to construct a hedged portfolio around a SolarCity position. You could also use a hedged portfolio approach if you don't currently own SolarCity but are considering buying it and want to limit your risk.

Let's review some of the basics of hedged portfolios, and then see how we can go about building one around a SolarCity position for an investor with $250,000 to invest, who wants to maximize his potential return given the constraint that he wants to limit his downside risk to a drawdown of no more than 16% in a worst-case scenario.

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:

  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. Presumably, if you own SCTY (or are considering buying it), you expect it to have a decent return from here. To find other securities with high expected returns to complement it, you could, for example, look at the holdings of a top buy & hold stock blogger, as we did with Eddy Elfenbein's 2014 buy list in a recent article ("Investing Alongside The Best Buy & Hold Blogger While Limiting Your Downside Risk"). Or, if you want to have a more renewable energy-focused portfolio, you could look at the top holdings of a highly-rated green tech fund. To quantify expected returns for these securities, you can, for example, use analysts' price targets for them and then convert those 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 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-16% 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'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 names in your sort 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. For example, 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 left over 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 around a SolarCity position 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 symbol SCTY, the dollar amount of our investor's portfolio (250000), and the maximum decline he's willing to risk in percentage terms (16). We'll leave the strategy set to the default, "Maximize Potential Return".

In the second step, we're given the option of entering our own expected return for SCTY. In this example, we will leave this blank, and use the tool's own expected return calculation.

A few minutes after clicking the "create" button, we were presented with this hedged portfolio. The data in it are as of Thursday's close.

Why These Additional Securities?

In addition to SolarCity, the tool added Actavis plc (NYSE:ACT), Las Vegas Sands (NYSE:LVS), Wynn Resorts (NASDAQ:WYNN), and Biogen (NASDAQ:BIIB) to the portfolio in its primary allocation, based on their high net expected returns. Each of these securities was hedged with an optimal collar with its cap set at the security's expected return. As part of its fine-tuning step, the tool added BIIB again, this time as a cash substitute, hedged with an optimal collar with its cap set at 1%. Note that the hedging costs and net expected returns for these positions are quite different, even though both contain the same underlying security.

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 is a closer look at the hedge for SolarCity.

As you can see in the image at the link above, SCTY is hedged with an optimal collar with its cap set at 18%. Using an analysis of historical returns as well as option market sentiment, the tool estimated a return of 18% for SCTY over the next several months. That's why 18% 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 SCTY if it appreciates beyond 18% over the next several months. Now, if you believe that the stock will appreciate by much more than 18% over the next several months, remember, you can enter your own expected return for the stock in Step 2 above. 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 an investor would essentially get paid when opening this hedge.[i]

Negative Hedging Cost

As you can see below in the summary for this hedged portfolio, the hedging cost of the entire portfolio (which includes the hedging cost of the SCTY position above) was negative: an investor would have collected about $1,562 more from selling the call legs of the hedges than he would have paid for the put legs.

Higher Risk, Higher Potential Return

As we noted 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 16% decline, features a potential return of 18.6% over six months.

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 actual return of this portfolio may trail its potential return. But in the worst-case scenario - if SolarCity and every other one of these securities went to zero before their hedges expired - the investor's downside would be strictly limited to a decline of 14.31%.

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[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, an investor may have collected more than $375 when opening this hedge. Bear in mind that if we had entered a higher expected return for the SCTY in Step 2, all else equal, the cost of hedging it would have been higher as well.

Source: Building A Hedged Portfolio Around A SolarCity Position