Mohnish Pabrai: swinging for the fences again?
In his brief book, "The Dhando Investor," hedge fund manager Mohnish Pabrai devoted a chapter to the Kelly formula before concluding that, rather than follow it exactly, he was motivated by it to aim for a 10x10 portfolio (ten positions each comprising 10% of his portfolio). According to notes on his 2009 investor meeting, Pabrai moved further away from the Kelly formula, to a 3-5-10 set up, where he would only allocate 3% or 5% to most positions, and only occasionally allocate 10% to one idea under extraordinary circumstances. Remembering that, I was surprised to see the position weightings of Pabrai's top 7 holdings, as reported by Lalit Sharma in a recent article ("Mohnish Pabrai's Top 7 Holdings"), which showed 18.72% of Pabrai's holdings are invested in Bank of America (BAC) now. Perhaps Pabrai has gone back to swinging for the fences with a concentrated portfolio?
Hedging Pabrai's top 6 stocks
Pabrai's seventh biggest holding, the South American agricultural company Cresud Inc. (CRESY) doesn't have options traded on it in the U.S., so it can't be hedged with optimal puts. The table below shows the costs, as of Friday's close, of hedging the 6 biggest holdings against greater-than-20% declines, using optimal puts.
For comparison purposes, we'll also look at the cost of hedging the SPDR Dow Jones Industrial Average ETF (DIA) against the same decline. First, a reminder about what optimal puts are, and a note about the 20% as decline threshold. Then, a screen capture showing the optimal puts to hedge one of these six stocks, Bank of America Corporation (BAC).
About Optimal Puts
Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor 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.
In this context, "threshold" is the maximum decline you are willing to risk. Another way of thinking about it is this: the percentage you can tolerate losing. In this case, since we're using 20% as a decline threshold, we are indicating that we could tolerate a 20% loss, but not a loss greater than that. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position). In the example below, you'll see that hedging BAC against a 20% drop costs nearly that much, as a percentage of position.
The Optimal Puts to Hedge Bank of America
Below is a screen capture showing the optimal put option contract to hedge 100 shares of BAC against a greater than 20% decline as of Friday's close. A note about these optimal put options and their cost: To be conservative, Portfolio Armor calculated the cost based on the ask price of the optimal puts. In practice an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.
Hedging Costs As Of Friday's Close
The hedging costs below are presented as percentages of position values. Note that some of these names are quite expensive to hedge. Another risk management approach to consider is to use diversification to minimize stock-specific risk, and then use optimal puts on an index-tracking ETF such as SPDR Dow Jones Industrial Average (DIA) to hedge against market risk.
|BAC||Bank of America Corporation||19.2%*|
|BIP||Brookfield Infrastructure Properties||5.97%**|
Potash Corp of Saskatchewan
Wells Fargo & Company
*Based on optimal puts expiring in May, 2012
**Based on optimal puts expiring in June, 2012
***Based on optimal puts expiring in July, 2012
Additional disclosure: I am long puts on DIA.