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Bruce Berkowitz and Bank of America

When Bruce Berkowitz, portfolio manager of the Fairholme Fund, gave his presentation to the Association of Individual Investors in New York, in June ("Beat the Back by Breaking from it,") he spent more time talking about one of his fund's holdings, Bank of America Corporation (NYSE:BAC), than any other. The steep drop in Bank of America shares since prompted me to look back at its relative hedging costs over time, as I've tracked them in posts about hedging the Dow.

High optimal hedging costs as a red flag?

Since late March, I've updated the hedging costs of each Dow component, and the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA), using optimal puts, seven times. In 5 of those 7 posts, starting with this one published on April 21, "Hedging the Dow, an Update", BAC had the highest hedging costs of any Dow component. Let's take a look at the table from that article published pril 21, but first, a quick reminder about optimal puts.

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 on the web 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 -- you can enter any percentage you like, but the larger the percentage, the greater the chance there will be optimal puts available for the position). 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.

Hedging costs of the Dow and its components as of April 20th

The table below shows the costs, as of April 20, 2011, of hedging each Dow component, and the Dow-tracking ETF (DIA), against greater-than-20% declines over the next several months.

Symbol

Name

Cost of Protection (as % of Position value)

(NYSE:AA)

Alcoa Inc. Common Stock

3.19%**

(NYSE:AXP)

American Express

2.13%**

(NYSE:BA)

Boeing

3.04%***

(BAC)

Bank of America

4.89%***

(NYSE:CAT)

Caterpillar

4.39%***

(NASDAQ:CSCO)

Cisco Systems

2.01%**

(NYSE:CVX)

Chevron

1.47%*

(NYSE:DD)

E.I. du Pont de Nemours

2.87%**

(NYSE:DIS)

Walt Disney

1.97%**

(NYSE:GE)

General Electric

1.91%*

(NYSE:HD)

Home Depot

2.53%***

(NYSE:HPQ)

Hewlett-Packard

2.79%***

(NYSE:IBM)

International Business Machines

1.20%**

(NASDAQ:INTC)

Intel

1.91%**

(NYSE:JNJ)

Johnson & Johnson

0.7%**

(NYSE:JPM)

JP Morgan Chase

1.57%*

(KFT)

Kraft Foods

0.72%*

(NYSE:KO)

Coca-Cola

1.00%***

(NYSE:MCD)

McDonald's

0.68%*

(NYSE:MMM)

3M

1.95%**

(NYSE:MRK)

Merck

1.41%**

(NASDAQ:MSFT)

Microsoft

2.17%**

(NYSE:PFE)

Pfizer

1.47%*

(NYSE:PG)

Procter & Gamble

0.86%**

(NYSE:T)

AT&T

1.43%**

(NYSE:TRV)

Travelers

1.69%**

(NYSE:UTX)

United Technologies

2.15%***

(NYSE:VZ)

Verizon Communications

1.53%**

(NYSE:WMT)

Wal-Mart Stores

0.75%*

(NYSE:XOM)

Exxon Mobil

1.39%**

(DIA)

SPDR Dow Jones Industrial Average ETF

0.67%*

*Based on optimal puts expiring in September, 2011.

**Based on optimal puts expiring in October, 2011.

***Based on optimal puts expiring in November, 2011

Volatility on April 20th

The VIX closed at 15.07 on April 20th, prompting me to note in my article then that,

Volatility can spike quite quickly though, so if you are considering hedging, you may want to consider doing so while volatility remains relatively low.

Note how low the costs of DIA against a >20% drop were back then -- 0.67% of your position, using optimal puts expiring in September.

The highest hedging costs in the Dow on April 20th

The cost of hegding BAC against a >20% drop over the next several months was 4.89%, the highest of any Dow component on April 20th.

The trajectory of Bank of America Corporation since then

The chart below shows the performance of BAC from April 20th to August 10th -- down 45.14%.

(Click charts to enlarge)



Contrast with The Coca-Cola Company

In the table above, Bank of America was one of 7 Dow components with optimal puts expiring in November (all things equal, options with more time to expiration will cost more). Of those 7 Dow components, the one with the lowest hedging costs on April 20, was The Coca-Cola Company (KO). The chart below shows the performance of KO versus the Dow Jones and BAC from April 20th to August 10th -- KO was only down 4.67% over that time period.



Four Dow stocks with the lowest hedging costs on April 20th


Disregarding the differences in options expiration dates, there were four stocks in the table above for which the costs of hedging against >20% declines was less than 1%: Wal-Mart Stores, Inc. (WMT), Kraft Foods Inc. (KFT), Procter & Gamble Company (PG), and McDonald's Corporation (MCD). The chart below shows how they've performed since April 20. Note that all have outperformed the Dow over that time period.



Four Dow stocks with the highest hedging costs on April 20th

Disregarding the differences in options expiration dates, there were four stocks in the table above for which the costs of hedging against >20% declines was greater than 3%: Bank of America, Alcoa, Inc. (AA), The Boeing Company (BA), and Caterpillar, Inc. (CAT). The chart below shows how they've performed since April 20. Note that they've all underperformed the Dow (and the stocks with the lowest hedging costs) over that time period.



Are optimal hedging costs performance indicators during downturns?


It's an interesting hypothesis, but I would want to see a lot more data on it before using it as a basis for picking stocks. Fortunately, we may see that data soon. One of the quants on the Portfolio Armor team is starting a postdoctoral fellowship at a university this fall, where he should have access to extensive historical options data on which we can experiment with some applications of Portfolio Armor's algorithm to areas beyond hedging, such as stock picking. Stay tuned.


Disclosure: I am long optimal puts on DIA as a hedge.