Stay Invested And Hedge

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Includes: SPY, TLT
by: David Pinsen

Summary

Janus bond prince Bill Gross warned Bloomberg on Wednesday that market risks were at their highest levels since 2008 and described investing now as "buying high and crossing your fingers".

We note that we've all heard similar warnings since the current bull market began, and that investors may be better off staying invested and hedging than running for the sidelines.

We show a simple way of hedging a portfolio against market risk, and conclude with a thought about seeking a higher reward to risk ratio while hedging.

Screen capture via Twitter.

Market Warning Number LXXVI

Janus (NYSE:JNS) bond prince Bill Gross (pictured above), the former PIMCO bond king, warned Bloomberg this week that market risks were at their highest levels since 2008:

U.S. markets are at their highest risk levels since before the 2008 financial crisis because investors are paying a high price for the chances they are taking, according to Bill Gross, manager of the $2 billion Janus Henderson Unconstrained Bond Fund.

"Instead of buying low and selling high, you're buying high and crossing your fingers," Gross, 73, said Wednesday at the Bloomberg Invest New York summit. [...]

"If there's a common factor it's the expansion of credit... Money is being pumped into the system and money that is yielding less than nothing seeks a haven not only in bonds that are under-yielding but in stocks that are overpriced."

We labeled Gross's warning number LXXVI above (76 in Hindu Arabic numerals), but that was just a guess. How many warnings of market risk have we had since this bull market began? What sort of gains would you have given up had you gone to the sidelines the first time you heard one?

Screen capture via YCharts.

Bloomberg notes later in the article that Bill Gross isn't moving to the sidelines - as a fund manager, he has to stay invested. But individual investors concerned about market risk have another option besides moving to the sidelines or crossing their fingers: they can stay invested and hedge. We'll walk through a way of hedging a $1 million stock portfolio against market risk below.

Hedging A $1,000,000 Portfolio Against Market Risk

We'll use the SPDR S&P 500 ETF (NYSEARCA:SPY) here as a proxy for your stock portfolio, assuming your portfolio is highly correlated with the S&P 500. If you'd like a refresher on hedging terms first, see the section titled, "Refresher On Hedging Terms," here.

Pick A Number Of Shares

Since we're using SPY as our proxy ETF, in order to hedge a $1,000,000 equity portfolio against market risk, you would want to hedge an equivalent dollar amount of SPY.* Since SPY closed at $243.66 on Wednesday, you could divide your equity portfolio dollar amount, $1,000,000 by $243.66, to get 4,104. Note that 4,104 isn't a multiple of 100, and that options contracts each cover 100 shares. More on that below.

Pick Your Decline Threshold

As a shorthand, we call the maximum decline you are willing to risk your threshold. Generally, the larger that number is, the less expensive the hedge and vice versa. In some cases, a threshold that's too small can be so expensive to hedge that the cost of doing so is greater than the loss you are trying to hedge. A starting point to consider is this idea from Dr. John Hussman:

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'll use that for our example here.

Find the Optimal Puts

The idea here is to find the least expensive put options to protect 4,104 shares of SPY against a greater-than-20% decline. If you're going to do this manually, this is the basic approach. Given the time frame over which you are looking to hedge, you'd want to find the put options that would protect you against a greater-than-X% decline (where X is your threshold, in this case 20%) at the lowest cost. When doing so, you'd want to keep in mind the cost of the hedge: for example, if you can only tolerate a 20% decline, and there's a put option with a strike price 20% below the current market price, but it would cost 5% of your portfolio to buy it, then you are actually risking a 25% decline in that case. In most cases, the optimal puts will be out-of-the money, but on occasion, they may be in-the-money.

If you are looking to hedge a number of shares including an odd lot, the simplest (though not always the least expensive) way of doing that would be to round up to the next-highest round lot. We actually tried this two ways: once, using 4,104 shares, while slightly over-hedging the 4,100 shares so the total number of 4,104 shares was protected according to our specifications, and a second time, rounding up to 4,200 shares. It turned out that the first hedge was less expensive in dollar terms, so we'll show that one below (screen capture via an iOS hedging app).

Screen capture via the Portfolio Armor iOS app.

The cost, as you can see above, was $5,535, or 0.55% of your equity portfolio's value, to hedge out to mid-December. Note that, to be conservative, the cost was based on the ask price of the puts. Since you can often buy puts at some point within the bid-ask spread, you could have probably purchased these puts for less on Wednesday.

How This Hedge Would Protect Your Portfolio

If SPY drops more than 20% - if it drops 20.5%, 30%, 40%, or even more - the put options above will rise in price by at least enough so that the total value of a $1,000,000 position in SPY plus the puts will have only dropped by 20% in a worst-case scenario.

The hedge will offer that level of protection up until it expires in mid-December, but if there's a significant decline in the market in the near future, it may offer more protection than that due to time value.

Hedging A Portfolio Of Stocks And Bonds

The example above is simplified in that we've assumed that the non-cash part of our hypothetical investor's portfolio is entirely invested in stocks. But what if he had some bonds or bond mutual funds? In that case, we could use a similar process to hedge his portfolio against market risk, except instead of using just one proxy ETF, we'd use one per each asset class. So, for example, if 60% of the investor's assets were in blue-chip US stocks, and 40% in Treasury bonds, we might scan for optimal puts for a $600k position in SPY and then scan for optimal puts for a $400k position in the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT).

A Potentially Better Approach

Although the hedge shown above is inexpensive, the risk versus reward with this approach doesn't look great, assuming your portfolio tracks closely with the S&P. According to our system of estimating potential returns (explicated using Amazon (NASDAQ:AMZN) as an example in our previous article, Forget About Value Investing), SPY has a potential return of about 5.3% over the next six months. If we're in the ballpark with that estimate, then your best-case scenario here is a upside of a little under 5%, net of hedging cost, with a worst-case scenario of 20% (the threshold figure includes the hedging cost).

Compare that to the bulletproof or hedged portfolio we presented in a recent article (Introducing Bulletproof Investing), where the best-case scenario over six months was a gain of about 24%, and the worst-case scenario was a decline of a little more than 7%.

*We're assuming here that your stock portfolio is going to be highly correlated with SPY in the event of a correction. If you want to complicate this in the hopes of adding precision, you could calculate the beta of your portfolio first, and then adjust the number of SPY shares accordingly. But if precision is really your goal, you might consider the bulletproof portfolio approach, where each security in a concentrated portfolio is hedged directly, rather than via a proxy ETF as in the example above.

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

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.