Hedging a Permanent Portfolio

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 |  Includes: EEM, GLD, SPY, TLT
by: David Pinsen

The idea of a permanent portfolio, as developed by Harry Browne, was that at least one component of it would outperform in any economic enviroment, making up for the underperformance of the other components. Over the years, there have been a number of variations on the theme, but a simple version of permanent portfolio might consist of an allocation such as this:

  • 25% Stocks
  • 25% Gold
  • 25% Treasury Bonds
  • 25% Cash

Hedging a permanent portfolio

A common approach with permanent portfolios is to rebalance them on an annual basis. That enables an investor to sell a portion of an appreciated asset and use the proceeds to average down on assets that declined over the previous year. Hedging opportunistically, when it's relatively inexpensive to do so, can potentially complement this strategy of buying low.

An example of opportunistic hedging

In the May issue of Private Wealth Magazine ("Growing The Single-Family Office"), family office manager David Cohen offered an example of how his firm's opportunistic hedging enabled it to limit his client's downside during the 2008 crash and create cash with which he could buy undervalued assets:

The large profits from this trade [purchasing equity index put options when they were inexpensive, and selling them after the crash] helped to insulate the portfolio from a massive down stroke in 2008, and provide liquidity, which set us up for a big recovery in 2009.

A step by step example of hedging with optimal puts

Gold hit a record high of $1,628.30 an ounce Friday, as it became apparent that debt ceiling talks would go down to the wire. Since gold is often a component of permanent portfolios, below we've demonstrated a way to hedge gold, using optimal puts on the SPDR Gold Trust ETF (GLD) as a proxy for it. First a quick reminder about what optimal puts means in this context.

About optimal puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. As University of Maine finance professor Dr. Robert Strong, CFA has noted, picking the most economical puts can be a complicated task. With Portfolio Armor (available in Seeking Alpha's Investing Tools Store and as an Apple iOS app), you just enter the symbol of the stock or ETF you're looking to hedge, the number of shares you own, and the maximum decline you're willing to risk (your threshold). Then the app uses an algorithm developed by a finance Ph.D to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

Step 1: Enter a ticker symbol

In this case, we're using GLD as a proxy for the gold component, but an investor could use the same approach to hedge other components of his permanent portfolio. Here are examples of other optionable ETFs that could be used as proxies to hedge other components of a permanent portfolio:

  • Stocks: The SPDR S&P 500 Trust ETF (SPY), or, if the investor has allocated his stock component to emerging markets, iShares MSCI Emerging Markets ETF (EEM).
  • Treasury Bonds: iShares Barclays 20+ Year Treasury Bond (TLT)

Since we're using GLD here, we've entered GLD in the Ticker Symbol field below.

[Click all to enlarge]

Click to enlarge
Step 2: Enter a number of shares

For the purposes of this example, let's assume the investor has a $4 million portfolio, with $1 million each allocated to cash, Treasury bonds, gold, and stocks. Since he's got $1 million in gold, and we're using GLD as a proxy, the number of shares we'll enter will be $1,000,000 / the most recent share price of GLD ($158.29, as of Friday's close) = 6,317.5. We've rounded that up to 6,318 and entered that number in the "Shares Owned" field in the screen cap below.
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Step 3: Enter a decline threshold

You can enter any percentage you like for a threshold when using Portfolio Armor (the higher the percentage though, the greater the chance you will find optimal puts for your position). The idea for a 20% threshold comes, as I've mentioned before, from a comment fund manager John Hussman made in a market commentary in October 2008:

An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).

Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery. So we've entered 20% in the Threshold field in the screen cap below.
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Step 4: Click the red button

A moment after clicking the red button, you'd see the screen cap below, which shows the optimal put option contracts to buy to hedge against a >20% drop in GLD between now and January 21, 2012. The cost of this protection on a $1 million position would be $4,788, or about 0.48% of the position value.
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Hedging Costs as of Friday's Close

In additional to GLD, the table below shows the current hedging costs of the other three proxy ETFs mentioned above, as of Friday's close.

Symbol

Name

Cost of Protection (as % of position value)

GLD

SPDR Gold Trust

0.48%*

SPY

SPDR S&P 500

2.68%**

EEM

iShares MSCI Emerging Mkts

4.56%**

TLT iShares Barclays 20+ Year Treasury Bond 0.94%**
Click to enlarge

*Based on optimal puts expiring in January, 2012

**Based on optimal puts expiring in March, 2012

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am long puts on TLT as a hedge.