Protecting Your Equity Portfolio For Less - Part XII

| About: iPath S&P (VXX)


This article begins with an overview of previous what has been covered in previous article in this series to provide links and references for new readers.

A summary section follows to explain the basics of how this hedging strategy is designed to work, including a link to a more detailed explanation.

Why I do not use VXX in my equity hedging strategy including an explanation of how and why VXX varies significantly from the VIX.

Back to Part XI

In the first article of this series I provided an overview of the strategy to protect an equity portfolio from heavy losses from a market crash of 30 percent or more. In Part II I provided more detailed explanation of how the strategy works and gave the first candidate company to use as part of a diversified basket using put option contracts. I also provided an explanation of the selection process and an example of how it can help grow both capital and income over the long term because it conserves capital during downturns without selling your long-held equity positions. In Part III I provided a basic tutorial on options contracts, which I believe is necessary to make sure readers understand the basic mechanics and correct uses, as well as the risks involved when using options.

In this and the remaining articles in this series I will provide a short summary of the strategy and either an update on the option positions that I either have or will have purchased or my reasoning for using or not using alternative methods of hedging. So, in future articles those who are reading the complete series could skip over the summary portion because that will tend to be redundant for them. I am providing the overview primarily for the benefit of readers who are new to this series. However, if you are new to the series and like what you read here I strongly recommend going back to the beginning to get the full picture when you have finished this article.

First, I want to reiterate that I am not predicting a market crash. I want to make that clear. But bear markets are part of investing in equities and I find that taking some of the pain out of the downside helps make it easier to do the right things: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects; and then hold onto to those investments forever unless one of the fundamental reasons we bought them in the first place changes. Investing long term works! I just want to help make it work a little better and be a little less painful. History teaches us that bear markets are inevitable. Those who believe that the market will just continue higher without ever correcting more than 15 percent again are in a state of dreamy denial. That is not to say that a bear market is imminent. No one knows with any great certainty when the next downturn will occur. But the fact is that we are closer to the beginning of a bear market now than we were a year ago.

We are already past the average duration of all bull markets since 1929. Actually, by April of this year, the current bull market will have surpassed in length all but three bull markets during that time period (out of a total of 15). Thus, I have decided that it is time to start preparing for the inevitable next bear market. I intend to employ this hedge strategy in four stages over the next few months which will allow me to average into the full position I intend to build. I do not know when the strategy will pay off, but experience tells me that we are probably within a year or two from needed to be protected. It is not fun to write about down markets, but the fact is: they happen. I don't mind sustaining a setback of five or ten percent or even 15 percent from time to time. But I do try to avoid the majority of the pain from larger market drops. To understand more about the strategy, please refer back to the first three articles of this series. Without that foundation, the rest of the articles in this series won't make as much sense and could sound more like speculating with options. That is absolutely not my intention.

A Short Summary

The strategy is simply based upon the expectation that the weaker companies in those industries which are generally more adversely affected by economic contractions will fall further than the market averages. We use this expectation, along with the power of leverage and limited risk provided by options to construct a hedge position designed to protect as much of a diversified equity portfolio as an investor wishes. I suspect that the strategy is best explained by a hypothetical example. For that, I will use an abbreviated version of the example provided in Part II.

If the equity position of your portfolio had been about $500,000 in January of 2000 and you were invested in the S&P 500 Index, at the low point in 2002 the value of your portfolio would have dropped to approximately $255,000. Yes, the buy-and-hold investors would eventually see their portfolio value increase again to levels above the original $500,000, especially if they reinvested dividends. What we are trying to do with this strategy is to reduce that temporary setback from $230,000 to something less than $100,000 (the smaller the better). The difference of saving over $100,000 in principle can add significantly to a portfolio's growth over the longer term. We give up some of the income/appreciation near the top of the bull, but save the majority of our capital from loss to continue building our portfolio without having to dig out of those huge holes.

To take that example a little further, let us assume that you are using the dividends in retirement and unable to reinvest the earnings. Let us also assume that you are no longer saving from other sources and cannot add additional capital to your portfolio to increase your investments. So, now all we are measuring is the capital appreciation of your portfolio. If your portfolio value had been $500,000 in January of 2000 at the top and $255,000 in October of 2002 at the bottom, your portfolio would have climbed its way back up to $520,000 by July of 2007. Then it would have dropped back down to roughly $220,000 by early March of 2009. Today, the value of your portfolio would be back up to about $580,000. Assuming your stocks pay a rising stream of dividends you would be doing just fine.

If the same investor had used the strategy outlined in this series of articles, but would have only achieved a 50 percent hedge against those huge losses the outcome would have been drastically different. Today, instead of having about $580,000, you would have approximately $1,200,000 in your portfolio. The difference is staggering at $640,000! That is more than double the asset accumulation over a period of less than 15 years. For a more detailed explanation of how these results are calculated please refer back to Part II.

You may achieve better results than in the example or you may achieve poorer results than in the example. The point here is not how to get rich; it is merely a strategy to reduce your losses to enable you to keep your portfolio working harder for you. Now, I want us to look at the income side of the equation. In reality, your portfolio of equities will fall by the full amount of the market loss. But the options contracts will increase in value to offset a portion of those losses. Your income remains nearly the same from your original portfolio (minus the 5% each time used in the protection strategy). But, when you unwind your hedge positions you sell the option contracts for a gain. Assuming you simply add more of the shares that you originally owned so the yield does not change your income would now have increased by about 110 percent from what it would have been using a straight buy-and-hold strategy.

I hope that explains better the why of considering this strategy. A good article by another SA author about a couple of reasons why the market may falter soon can be found here. It is a well-reasoned article, especially in the second half where the author discusses catalysts that could cause a market correction. The author is a portfolio manager which, to me, means that he needs to remain relatively positive in order to support the sales of fund shares. Thus, he predicts a muted correction in the range of 15-20%. The article debunks the idea that we are heading into a repeat of 1929. I suspect, on that point he may be right, but that reality will fall somewhere in between the results of the Great Depression and his prediction.

Now I want to explain why I do no use the iPath® S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) in my hedging strategy. Here is the description of VXX provided in Yahoo! Finance:

"The iPath® S&P 500 VIX Short-Term Futures ETN is designed to provide investors with exposure to the S&P 500 VIX Short-Term Futures Index Total Return. The S&P 500 VIX Short-Term Futures Index Total Return is designed to provide access to equity market volatility through CBOE Volatility Index® futures. The Index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500® at various points along the volatility forward curve."

The problem I find with using VXX is that it does not do an adequate job of capturing the daily volatility of the VIX. Below are two charts to demonstrate this issue. The first chart is the five-year chart for the VIX and the second chart is the five-year chart for the VXX. Notice a difference?

VIX data by YCharts

VXX data by YCharts

Since the VXX is built on futures it is more forward looking than the VIX. The VIX measures volatility of the S&P 500® in a near real-time fashion. VXX reflects expectations of volatility over the next one to four months. VXX is based upon decaying securities. It is important to note that VXX has split four for one three times over the last four years, the first of which was in November 2010. Notice the almost constant downward slope on the VXX chart. Here is another chart I created using the monthly high, low and close quotes of historical prices from Yahoo! Finance over the last five years.

Chart created by Mark Bern; data source: Yahoo! Finance

You can see when the stock splits occurred (November 2010, October 2012 and November 2013), each one marking the bottom of a downward price trend and concurrently the top of the next trend.

There are two primary factors causing the VXX slope. First, is the decaying of the time value of the front month futures contract. As the expiration date approaches, there is less time for a significant change to occur so the time value just keeps falling. Much of the decaying factor in time value occurs in the last two months of a futures contract. Since the closest expiration is generally within two months the decay in this portion of the ETN is very high. The second factor causing decay is the daily reset of the price. What this means is that each day the price varies based upon the percentage change in the price of the futures contracts (since it is a combination of two separate contracts with two distinct prices). When the price trends up and resets the percentage change for the same change in price is smaller than when the price goes down over time. Here is an example to illustrate:

Starting price is $42 per share. The price goes up $0.50 thus the percentage change is 1.25 percent. The price is now $42.50. Now the price rises again by another $0.50 resulting in a percentage change of 1.18 percent. When the price goes down by the same amount the first day percentage is the same, 1.25 percent. But the second drop in price of $0.50 results in a change of 1.27 percent.

Add in the decaying factor of time into the daily reset factor and the value of VXX has too much natural downward pressure to justify holding for any length of time. VXX can work as a very short-term hedge, but if it is held for several months it is likely to result in a loss. I do not like holding a security where the odds are stacked against me. The structure of VXX is definitely stacked against us if we try to hold as a hedge over a multi-month time frame. Therefore, I do not recommend buying the VXX to hold as a hedge. If we could buy the VIX, or another security that behaves closely to how the VIX does, I would take a closer look.

My feeling is that, due to the uncertainty of how much longer this bull market can be sustained and the potential risk versus the potential reward of hedging versus not hedging, I would prefer to risk a small portion of my capital (perhaps up to five percent) to ensure that I hold onto the rest rather than risking losing a much larger portion of my capital (30 percent or more). But this is a decision that each investor needs to make for themselves. I do not commit more than five percent of my portfolio value to an initial hedge strategy position and have never committed more than ten percent to such a strategy in total. The ten percent rule can come into play when a bull market continues longer than expected. And when the bull rages on longer than it should the bear that follows is usually deeper than it otherwise would have been. In other words, I would expect a much less violent bear market to occur if it begins in 2014; but if the bull can sustain itself well into 2015, I would expect the results of the next bear market to be more pronounced. If my assessment is correct, protecting a portfolio becomes even more important as the bull market continues.

I also want to stress that this strategy, as with any options strategy, contains risk of loss. Since we are buying put option contracts the loss is limited to the initial premium cost of the options contracts (plus commissions). However, the beauty of this strategy is that it only requires one of the multiple positions taken to work to cover the entire cost of all the options contracts purchased, including the commissions. If more than one position meets my expectations we begin to benefit from additional gains, thereby protecting a portion of our portfolio. If there is no recession, then it is very possible that none of the positions will meet our expectations and that we will lose all of the money invested in this strategy. Conversely, since we are trying to choose some of the weakest players in each industry, there is always the possibility that it won't require a recession for one of these companies to stumble. Remember, it only takes one to work in order to cover our costs. That is also why I suggest that to properly employ the strategy we need to initiate at least eight positions in eight different companies' stocks. That also provides a more diversified approach so we don't miss better results because we focused our hedge too narrowly if a recession does hit.

It is my hope that readers have found this article to be useful. As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other's experience and knowledge.

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.