Protect Your Portfolio Like A Pro

| About: ProShares S&P (SPXT)

Summary

Investors are familiar with various risk management techniques. Many of them require almost no mathematical application. They have their own pros and cons.

I want to show how institutional investors hedge their portfolios.

Derivatives, couples with cross-asset hedging, can serve as powerful risk management tools for long-term investors.

Whether you are an income investor, a buy-and-hold investor, an index investor or any investor exposed to long time periods, you must have thought about risk management at some point in your investing life. I have read a lot of material that suggests that investors utilize risk management tools like diversification or cross-asset capital allocation (e.g. investing in bonds or real estate) in order to successfully manage market risk. Although I believe these methods generally work, I am not okay with the fact that these methods are too simple and, therefore, do not require existing investors to really learn anything new (except, maybe, valuation of other asset classes). I am really into learning new things, especially, when it comes to something math-based.

I have an understanding that a lot of Seeking Alpha readers are familiar with financial derivatives, in particular, with stock options. These instruments, when used wisely, can be great risk management tools. The problem with them is that they can be very expensive relative to the benefits they provide. In fact, they can be so expensive that a rational long-term investor would not even consider them as a viable option:

(Source: BlueBay Asset Management)

In the illustration above, you can see a comparison between investing into an index fund such as ProShares S&P 500 Ex-Technology ETF (NYSEARCA:SPXT) and investing in the same fund and hedging its downside exposure with out-of-money put options (evidently, with strike prices located 5% below the units' market prices and renewed every three months).

As you can see, over a five-year period or so, the difference in returns amounted to staggering 40%! On top of that, it is clear that as time went by, the difference between the back-tested results grew bigger. Hence, simply buying put options on standalone stocks or indexes is simply not the best way to do investing. After all, over longer time periods investors are better off "sucking up" losses and waiting for market rebounds than paying such a hefty price for peace of mind. History shows that dramatic declines are, in fact, not that frequent and do not last long.

It turns out that more complex option strategies are not only a lot more cost-effective but they also are a lot more predictable in their behavior at different price levels:

Click to enlarge

(Source: BlueBay Asset Management)

This means that you can essentially map out almost any outcome and see how your portfolio will likely perform under each scenario. Let us go over the option strategies shown in the above illustration and see how they pertain to portfolio risk management.

Puts - buying put options is arguably the simplest form of hedging unwanted downside exposure. Unfortunately, it is also the most expensive one. In addition, if investors are unfamiliar with how options are priced in general, they may also tend to purchase this type of insurance at the wrong time and price.

Put Spreads - in this context, a put spread means buying an out-of-money put option with a certain strike price and simultaneously selling one with a farther strike price. The benefit of this strategy is that it can significantly reduce the cost of insurance (you will see this later in my own example).

Of course, there is no free lunch, especially, in risk management. The main problem with put spreads is that they provide limited insurance - only down to a certain level. If the market falls through the strike price of the sold put, your portfolio will suddenly become exposed to the entire downside risk it was hedged against before this situation (i.e. the sold put will take away all insurance provided by the purchased put option after the price of the underlying asset breaks below the sold put option's strike).

Calendars - as far as I understand, in this case, it means an option strategy that utilizes options with different expiration dates. For example, investors can do put spreads by buying/selling short-tenor puts and simultaneously buying/selling longer-term puts in order to decrease the cost of insurance and/or change their portfolios' risk profiles.

Collars - a collar is a powerful portfolio insurance technique that involves buying puts and financing them with out-of-money call options (by selling these). The upside exposure is covered by the securities in the portfolio, while the downside exposure is completely insured.

Ideally, investors would want to sell calls in such manner that their insurance is effectively free (by matching the funds received from the sale of the calls with the cost of the puts purchased). Because the market can only move in one direction at a point in time, this strategy is very powerful. Of course, investors can also work with options with different expiration dates, utilizing the logic of the Calendars strategy.

Back-tested data show that collars, which also used put spreads (i.e. one financed the puts not only with the sale of the calls but also by selling puts with lower strike prices than the puts purchased), not only managed to show better results in terms of risk management by allowing a smaller drawdown in 2008 but also provided an enhanced overall portfolio return over the time period selected for presentation:

Click to enlarge

(Source: BlueBay Asset Management)

It should be noted, however, that, if the market meltdown continued for a longer time period, this strategy would underperform the simpler collar strategy.

Now, these slides are great for information and learning purposes. But what about the practical application of these option strategies?

Practical Approach

I often use simulators, such as the Investopedia Stock Simulator, to test different investing strategies (e.g. event-driven, derivative-linked, short-selling, etc.). I do this so I can make sure they work before I trust my real money with them. As a result, I have built quite a portfolio on this simulator:

Click to enlarge

(Source: Investopedia.com, Google Finance, Yahoo Finance. Calculations by author)

Note: the size of the initial portfolio is $500,000. Dividends are not recorded by the simulator, nor can one model options selling with the simulator, which is a big limitation of it. The prices shown are as of Tuesday's, May 17, 2016, market close. A few stocks on the list are hedges to respective derivative positions.

As you can see, the portfolio is quite diversified and holds 35 names in it. No single name exceeds 10% of the portfolio's value. The weighted-average beta of the portfolio, which is basically its sensitivity to the overall market, is just over 1.0. This means that my simulated portfolio is expected to be more volatile than the overall market. It is also assumed that it should show higher price returns in the long-run (as long as beta remains approximately the same).

To insure this portfolio over a three-month period (allowing a 5% loss) with put options only, I would have to pay a staggering price of almost 7%! Keep in mind that this is a three-month insurance. Obviously, this simply will not work in real life. Nobody is willing to pay almost 30% to insure his/her portfolio's downside exposure given a 5% "deductible"!

Collars show a better alternative: it "only" costs 4% over a three-month period to insure the portfolio. Unfortunately, this is still unacceptable. A collar and a put spread lower the cost to less than 1% over a three-month period (or about 4% a year). This is much better but still quite high. If your average dividend yield is around this amount, imagine that you would have to give away all cash earned to the insurance providers (by the way, transaction costs are excluded from the above calculations).

To sum up, what we can see from the above information is that insuring individual stocks within a portfolio can be very expensive, even if one uses advanced option strategies such as the subsidized collar (i.e. collar plus a put spread). Luckily, this is not the end of the story.

Cross-Asset Hedging

Imagine the following hypothetical case. You live in a village located near a large forest. The area is susceptible to severe forest fires. There is a high chance that all houses in the village will be destroyed in case of a big forest fire. Obviously, each homeowner in the village pays fire insurance. Your house is located on the outskirts of the village. This means that it will be the first one to get destroyed in the event of a forest fire. As a result, your insurance rates are higher than other villagers'. This is definitely a disappointing fact to you.

Now imagine that you could insure your house by actually insuring your neighbor's property. His insurance rates are lower than yours. You also know that a forest fire will likely destroy the entire village, so you will get a payout from the insurance company regardless. So why pay more?

This is exactly the logic behind cross-asset hedging. Since most asset classes are cross-correlated in some form or another and because during market crashes their correlation and sensitivity to each other (i.e. beta) grow, it is a lot more cost-effective to hedge other asset classes in order to hedge your own portfolio, however ridiculous this may sound. In my particular case, given the fact that the entire portfolio consists of stocks traded on US exchanges, this idea does not seem nonsensical at all.

I have chosen three instruments I can hedge in order to insure my own portfolio: the S&P 500 index (NYSEARCA:SPY), the NASDAQ index (NASDAQ:QQQ), and the VIX (NYSEARCA:VXX), which represents S&P 500's daily volatility:

(Source: Google Finance, Yahoo Finance. Calculations by author)

VIX's beta was unknown, so I had to run my own numbers:

(Source: Yahoo Finance. Calculations by author)

The idea is that I can do the same hedging strategies with options on these instruments and have my actual portfolio hedged with approximately the same effectiveness but at a much lower cost:

(Source: Google Finance, Yahoo Finance. Calculations by author)

The above table demonstrates a drastic difference between my initial cost of insurance and the cost of cross-asset hedging. It turns out that one can pay a laughable amount of money to insure a half-a-million dollar portfolio (for example, take a look at S&P 500 or VIX's subsidized collars). The difference between the two methods becomes even greater when one takes into account transaction costs (imagine executing 35 separate collars versus doing just one or two transactions once in three months).

Despite the positive findings demonstrated above, cross-asset hedging is not a panacea.

Coming back to our hypothetical example, imagine that the forest fire only destroys houses on the outskirt of the village. This means that your house is destroyed, while your neighbor's house, which you have insured, is in good standing. As a result, you have just lost your property and have paid insurance all these years in vain!

The same situation can take place with your investment portfolio. It is especially probable if your portfolio is well-diversified and has a low correlation with the overall market. Our assumption that correlations grow stronger during market crashes and the betas become equal is valid in most cases. However, this is true on really bad days like the ones witnessed during major market crashes throughout the history.

Secondly, the subsidized collar strategy, which is the cheapest one on the list, provides protection only down to a limit. In the context of the hypothetical example it is synonymous to having insurance up to a certain price point. Suppose, you had a 5% deductible, and the insurance policy covered only about 50% of your property value. If the fire destroys less than half of your house, this may work just fine. However, if the entire house is gone, you are in a big trouble.

The same is true with your investment portfolio. It is true that the collar will provide protection, say, up to a 20% drawdown, but if the market keeps tumbling, your portfolio will be bleeding just as anyone else's. The bright side of this, however, is that you will be able to use the premium collected from the options to buy more shares at a lower price without the need to contribute more of your own money to the portfolio. This is very beneficial to long-term investors.

Conclusion

My hypothetical example and a simple portfolio analysis have, hopefully, taught you about a new method of portfolio risk management. As all other risk management techniques, this method also has certain limitations to it and may prove to be ineffective in some circumstances. I think the key takeaway here is that investors need not limit themselves to the simple risk management techniques they already know and sit on the sidelines when other, more quantitative, portfolio insurance tools are evolving.

The strategies presented above are not in the domain of institutional investors only - anyone can buy and sell stock and index options for various purposes, including portfolio insurance. Openly available software and online calculators can do all number-crunching for you. All you need to do is spend some time on developing a rigorous risk management strategy, which will save you hard-earned dollars in the long-run.

Disclosure: I am/we are long QQQ, SPY.

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.