Rising Correlations Limit the Benefit of Diversification
A lesson investors learned from market meltdowns in 2011 was that although diversifying among a basket of different stocks can reduce stock-specific risk, it doesn't protect against market risk. When the market tanks, nearly all stocks get hammered. That was the case on August 4th of last year, for example, when the S&P 500 dropped about 4.7% in one day and 497 of its 500 component stocks were down on the day.
Rising Correlations also Limit the Benefit of Asset Allocation
Graham Bowley of the New York Times made a similar point about asset allocation in an article last week ("When Investors Rush in, and Out, Together"):
The prices of stocks, bonds and a host of other financial assets, which in normal conditions more often than not move in a diversity of unpredictable directions, are increasingly surging up or down in lockstep.
The rise in correlation between individual stocks, but also between completely separate asset classes like stocks and gold or stocks and oil, “has been one of the big themes of the investment climate this year,” said Marc Chandler, a market strategist at Brown Brothers Harriman in New York.
Another Way to Limit Risk: Hedging
Even when there are high correlations between individual securities and asset classes, investors can limit risk another way: by hedging. A couple of ways for a stock investor to hedge are by buying optimal puts on individual stocks, or on ETFs that track stock market indexes, such as the Dow-tracking ETF, SPDR Dow Jones Industrial Average (DIA). Investors in other asset classes, such as bonds or precious metals, can buy optimal puts on ETFs that track those asset classes.
The table below shows the current costs of hedging a handful of Dow component stocks against greater than 20% declines over the next several months, using optimal puts. It also shows the costs of hedging the Dow-tracking ETF, DIA, and ETFs that track two other asset classes, gold and Treasury bonds, respectively, against the same declines, using optimal puts. First, though, a reminder about what optimal puts are. Then, an example of optimal puts in action, followed by a screen capture of the current optimal puts to hedge the SPDR Dow Jones Industrial Average ETF.
About Optimal Puts
Puts are options that give an investor the right, but not the obligation, to sell a particular security at a specified price (the strike price of the option), on or before a certain date (the expiration date of the option). As such, the puts can offer protection for investors that own a security. 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.
Optimal Puts in Action
Above, we mentioned the market meltdown of August 4th, 2001. The screen capture below shows the performance of the S&P 500 tracking ETF SPDR S&P 500 Trust (SPY), the Dow-tracking ETF SPDR Dow Jones Industrial Average, and a few optimal put options on them that we had alluded to in Seeking Alpha articles earlier in the summer of 2011.
Up 74.77% On a Day the Dow dropped 4.29%
As I mentioned in an article at the time ("Lessons from Thursday's Market Meltdown"), this was the $98.75 strike put option on DIA expiring in December, 2011. In late June, I used Portfolio Armor to find the optimal put options to hedge against a greater-than-20% drop in DIA, and those were the ones Portfolio Armor presented. The screen shot below shows the quote for them on Thursday, August 4th, a day when the Dow Jones Industrial Average dropped 510 points, or almost 4.3%.
The Optimal Puts to hedge DIA Now
Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of DIA against a greater-than-20% drop between now and June 15, 2012. 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 Wednesday's Close
The table below shows the costs of hedging a handful of Dow component stocks, the Dow-tracking ETF DIA, along with two ETFs that track other asset classes, against greater-than-20% declines over the next several months, using optimal puts. Hedging costs are presented as percentages of position values.
Symbol | Name | Hedging Cost
|
| Dow Component Stocks | ||
| BAC | Bank of America Corporation | 13.8%*** |
| MSFT | Microsoft Corporation | 2.30%** |
| CSCO | Cisco Systems, Inc. | 3.69%** |
| INTC | Intel Corporation | 3.11%** |
| GE | General Electric Company | 3.23%* |
| Dow Jones Industrial Average | ||
| DIA | SPDR Dow Jones Industrial Avg. | 1.62%* |
| Gold | ||
SPDR Gold Trust | 1.01%* | |
| Treasury Bonds | ||
| TLT | iShares Barclays 20+ Year Treas | 0.48%* |
*Based on optimal puts expiring in June
**Based on optimal puts expiring in July
***Based on optimal puts expiring in August
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
