Worst Day For Nasdaq Since 2011 Highlights Its Risk
On Thursday (4/10/14), the Nasdaq suffered its worst one-day percentage decline since November 9th, 2011. Shares of the PowerShares QQQ ETF (NASDAQ:QQQ), which tracks the Nasdaq 100 Index, plunged 3.1%. Thursday's drop highlighted the way in which index ETFs are vulnerable to market risk. Although the diversification of index ETFs protects against stock-specific risk, it doesn't protect against market risk, when nearly all stocks go down. That was the case on Thursday, when 99% of the Nasdaq 100 stocks closed in the red. The only Nasdaq 100 stock that closed up on the day was C.H. Robinson Worldwide, Inc. (NASDAQ:CHRW), which, based on ProShares data, comprised about 3-thousandths of a percent of the Nasdaq 100 ETF's assets.
Risk Versus Return For The Nasdaq 100 ETF
In 2008, QQQ shareholders suffered a drawdown of about 42% within one six-month period. During the average six-month period over the last ten years, QQQ shareholders had a total return of about 4.73%. If you own QQQ, and are satisfied with that sort of risk versus reward, then you can continue holding it and skip reading any further. But if you're willing to consider another approach to investing in Nasdaq stocks, one that can offer a potential return greater than QQQ'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 QQQ 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 16% drawdown in the worst-case scenario (less than half the drawdown investors experienced during the period in 2008 we mentioned above), so his threshold here will be 16%.
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 two-fold:
- 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 Nasdaq stocks. If we were looking for securities with the highest expected returns, we wouldn't limit ourselves to just Nasdaq 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 QQQ ETF. To quantify expected returns for QQQ'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 is 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 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 QQQ and some of 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 ten of the larger holdings in the QQQ ETF. You could enter the top ten, or whichever of the holdings you like here, but I've left out Facebook (NASDAQ:FB) and Gilead (NASDAQ:GILD), as each appeared in a few recent hedged portfolios:
- Apple (NASDAQ:AAPL)
- Microsoft (NASDAQ:MSFT)
- Google (NASDAQ:GOOG)
- Oracle (NYSE:ORCL)
- Intel (NASDAQ:INTC)
- Amazon (NASDAQ:AMZN)
- Qualcomm (NASDAQ:QCOM)
- Cisco Systems (NASDAQ:CSCO)
- Comcast (NASDAQ:CMCSA)
- eBay (NASDAQ:EBAY)
In the second field, we 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 (16). 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 QQQ's top holdings. For this example, we'll leave these blank and let the tool use its own expected returns for these 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 5 of the 10 QQQ holdings we entered: Comcast, eBay, Intel, Microsoft, and Oracle. It excluded Google because it calculated a negative net expected return for it. It calculated positive net expected returns for the other stocks we entered, but because we entered a portfolio amount of $100,000, it excluded the stocks with the highest share prices, so it could present us with a portfolio of more than just 1 or 2 stocks. In its fine-tuning step, the tool added Eldorado Gold Corp. (NYSE:EGO) as a cash substitute due to its high net expected return and low hedging cost at a 16% threshold.
Each Security Is Hedged
Note that each of the above securities is hedged. Eldorado Gold, 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, Comcast:
As you can see in the image above, CMCSA is hedged with an optimal collar with its cap set at 8.03%. Using an analysis of historical returns, as well as option market sentiment, the tool estimated a return of 8.03% for AXP over the next several months. That's why 8.03% 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 that expected return 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 CMCSA (and each of the other QQQ holdings) in Step 2 above. As you can see at the bottom of the image above, the cost of the hedge for the CMCSA position was negative.^{[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 CMCSA position above) was negative: an investor would have collected about $3,402 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 7.64%. That's what the portfolio will return if each of its underlying securities achieves its expected return. The maximum drawdown for this portfolio is 15.96%: 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 15.96% in that worst-case scenario.
Worthy Of Consideration For QQQ Investors
Given that the potential return of this portfolio is higher than the average six-month return of QQQ over the last ten years, and the maximum drawdown risk of this portfolio is less than half of the worst drawdown QQQ investors experienced within a six-month period over the last ten years, this hedged portfolio approach is worthy of consideration for investors who currently own QQQ. Investors who would rather have higher potential returns at this level of drawdown risk should consider not limiting their security selection to the holdings of one index ETF. 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, an investor may have collected more than $49 for opening this hedge.
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.