## Summary

During the average 6-month period over the last 10 years, the financial sector ETF XLF has generated a return of -0.37%.

XLF shareholders suffered a drawdown of about 51% during one of those 6-month periods.

A hedged financial portfolio, such as the one shown below, can offer a higher potential return with less than half that drawdown risk.

This portfolio has a negative hedging cost, meaning an investor would essentially be getting paid to hedge with it.

## Sector ETFs, Diversification, And Risk

Sector ETFs are often thought of as a lower-risk way of investing in a particular sector. With a financial sector ETF, for example, you own a basket of dozens of stocks, which ameliorates the risk of a disaster occurring with one of them. Although the diversification of sector ETFs protects against stock-specific risk, it doesn't protect against sector risk: if a certain sector suffers the brunt of a bear market, as the financial sector did during the last bear market, diversification within that sector will do little to ameliorate an investor's risk.

## Risk Versus Return For A Financial Sector ETF

In 2008, for example, shareholders in the Financial Select Sector SPDR ETF (NYSEARCA:XLF) suffered a drawdown of about 51% within one six-month period. During the average six-month period over the last ten years, XLF shareholders had a total return of about -0.37%. If you own XLF, and are satisfied with that sort of risk versus reward, then you need not read any further. But if you're willing to consider another approach to investing in financial stocks, one that can offer a potential return greater than XLF's average return with less than half the drawdown risk, read on.

## When Stocks Can Be Safer Than An ETF

It may seem counterintuitive that you can be exposed to less risk by primarily holding individual financial stocks, 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 XLF for an investor with $500,000 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 20% drawdown in the worst-case scenario (less than half of the drawdown XLF investors experienced during the period in 2008 we mentioned above) so his threshold here will be 20%.

## 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 relatively 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 financial stocks.**If we were looking for securities with the highest expected returns, we wouldn't limit ourselves to financial stocks; instead we'd consider a much broader universe of stocks. But since we're concerned with financial stocks here, we'll start with the top holdings of the leading financial stock ETF, the Financial Select Sector SPDR. To quantify expected returns for XLF's top holdings, you can, for example, use analysts' 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-20% 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 positive net expected returns.**In order to determine which securities these are, out of the 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. 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 financial stock portfolio starting with XLF and its top holdings using the general process described above, facilitated by the automated portfolio construction tool at Portfolio Armor. In the first step, we enter the ticker symbol XLF, along with the ticker symbols of XLF's top holdings in the "Tickers" field. Those top holdings, as of March 20th's data, were:

- Wells Fargo (NYSE:WFC)
- JPMorgan Chase (NYSE:JPM)
- Berkshire Hathaway (NYSE:BRK.B)
- Bank of America (NYSE:BAC)
- Citigroup (NYSE:C)
- US Bancorp (NYSE:USB)
- American International Group (NYSE:AIG)
- Goldman Sachs Group (NYSE:GS)
- MetLife (NYSE:MET)
- American Express (NYSE:AXP)

In the second field, we enter the dollar amount of our investor's portfolio (500000), and in the third field, the maximum decline he's willing to risk in percentage terms (20). We leave the strategy in the fourth field set to its default, "Maximize Potential Return."

In the second step, we are given the option of entering our own return estimates for each of XLF's top holdings. For this example, we'll leave these blank and let the tool use its own expected returns for these financial stocks.

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

## Why These Securities?

In its initial allocation, the tool included 8 of the top 10 holdings in XLF. The only ones it didn't include were Citigroup and AIG, because it found that their expected returns, net of their hedging costs, were negative. In its fine-tuning step, the tool added TripAdvisor (NASDAQ:TRIP) as a cash substitute, due to its high net expected return and low hedging cost at a 20% threshold.

## Each Security Is Hedged

Note that each of the above securities is hedged. TripAdvisor, the cash substitute, is hedged with an optimal collar, with its cap set at 1%; the remaining securities are hedged with optimal collars with their caps set at each stock's expected return. These stocks were hedged with optimal collars instead of optimal puts because they had higher net expected returns when hedged with optimal collars. Here is a closer look at the hedge for the first position, American Express:

As you can see in the image above, AXP is hedged with an optimal collar with its cap set at 11.33%. Using an analysis of historical returns as well as option market sentiment, the tool estimated a return of 11.33% for AXP over the next several months. That's why 11.33% 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 AXP if it appreciates beyond 11.33% over the next several months. Now, if you believe that the stock will appreciate by more or less than that amount over the next several months, remember, you can enter your own expected return for AXP (and each of the other securities) in Step 2 above. As you can see at the bottom of the image above, the cost of the hedge for the AXP position was $0.[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 AXP position above) was negative: an investor would have collected about $13,288 more from selling the call legs of the hedges than he would have paid for the puts.

## Risk Versus Return For This Portfolio

As you can see in the portfolio summary above, the potential return of this portfolio over the next six months is 7.8%. That's what the portfolio will return if each of its underlying securities achieves its expected return. The maximum drawdown for this portfolio is 19.59%: if every one of the underlying securities in this portfolio went to zero before their hedges expired, the total value of our investor's portfolio would decline by only 19.59% in that worst-case scenario.

## Worthy Of Consideration For Financial Sector Investors

Given that the potential return of this portfolio is higher than the average six-month return of XLF over the last ten years, and the maximum drawdown risk of this portfolio is less than half of the worst drawdown XLF investors experienced within a six-month period over the last ten years, this hedged portfolio approach is worthy of consideration for financial sector investors who currently own XLF. Investors who would rather have higher potential returns at this level of drawdown risk should consider not limiting their security selection to one sector. An example of a hedged portfolio constructed that way -- one that selected securities with the highest net expected returns from all sectors -- was included in this article, "How To Maximize Potential Return While Protecting Against A Severe Correction." The portfolio in that article had a potential return of 21.41%.

[i] To be conservative, the net cost of the collar was calculated using the ask price of the puts and the bid price of the calls. In practice, an investor can often buy puts for less than the ask price (i.e., at some price between the bid and ask) and sell calls for more than the bid price (again, at some price between the bid and the ask). So, in practice, this hedge would likely have had a slightly negative cost.

**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.