Tracking Hedged Portfolio Performance

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Includes: BAC, CENX, IDTI, NFLX, NVDA, SPY
by: David Pinsen

Summary

To be transparent we will be posting publicly the performance of each "bulletproof", or hedged, portfolio we present to our Bulletproof Investing subscribers.

To this end we've invested in software development and subscriptions to options and underlying security price data. We've been archiving that data since March 7th.

Here we detail some of the challenges in performance tracking, explain our approach to it, and illustrate with portfolio created by one of our Portfolio Armor subscribers on March 7th.

Image via Bing. Tracking Performance In A Hedged Portfolio

Every week, we present hedged portfolios in our Bulletproof Investing service. In the interest of transparency, we've committed to publicly posting the performance of each portfolio we present in our subscription service. Here we address some of the challenges in tracking the performance of hedged portfolios, introduce our new tool for doing so, and use an actual portfolio created by a Portfolio Armor subscriber to illustrate (Portfolio Armor generates the hedged portfolios we present to our Bulletproof Investing subscribers).

Issues To Bear In Mind When Tracking Performance

There are several issues to bear in mind when tracking the performance of a portfolio. These include:

  • Dividends and other distributions.
  • Splits and reverse splits.
  • Trading costs.

When your portfolio includes options, you have a few more issues to keep in mind:

  • Bid-ask spreads, which in some cases can be relatively wide.
  • Expiration dates. Options may expire before the time period you are tracking ends.
  • Infrequent trades. Some options may not trade for more than a week at a time.

How We Address These Issues

We address trading costs by deducting them up on the way into and out of positions. We deduct the costs Fidelity charged up until recently: $4.95 per trade per underlying stock or ETF, and $4.95 + $0.65 per contract for options trades (Fidelity has since lowered its fees on certain options trades). And we address distributions and splits by using adjusted prices for underlying securities and adjusting option values accordingly.

So, for each underlying position, we calculate the dollar amount (number of shares x closing share price). Then we deduct the trading fees. And then we track the net dollar amount's worth of adjusted shares of the underlying security.

For hedges, to be conservative, we assume the investor buys his puts at the worst end of the spread, the ask, and sells his calls at the worst end of the spread, the bid. To track the value of the options going forward, we don't use the "last price", because it can be stale in the case of an option that doesn't trade frequently. Instead, we value the options at their intrinsic value or the midpoint of their bid-ask spread, whichever is higher. Will illustrate this below with an actual portfolio.

User-Generated Portfolio: 3/7/2017

We started saving option and underlying security data on March 7th, to facilitate performance tracking. The first portfolio created since then was this one, by a Portfolio Armor subscriber. He was seeking to maximize his return on an $250,000 investment while limiting his downside risk to a drawdown of no more than 16% over the next several months. So he inputted those figures into our site and was presented with the following portfolio.

Image via Portfolio Armor. The portfolio the user was presented included Bank of America (BAC), Century Aluminum (CENX), Netflix (NFLX), and Nvidia (NVDA) as primary securities because those securities had the highest potential returns, net of hedging costs, in our system. After rounding down dollar amounts to get around lots of each position, in its fine-tuning step, Portfolio Armor allocated as much of the leftover cash as possible to round lots of Integrated Device Technology (IDTI), as a "cash substitute": that's a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor's downside limited according to his specifications.

The idea with this portfolio was to hold each position for 6 months or until just before its hedge expired, whichever came first. The portfolio-level summary at the bottom of the screen capture above breaks down the main parameters of the portfolio:

  • Worst-case scenario ("Max Drawdown"): a decline of 15.68%.
  • Hedging cost: -0.13% (the user collected a net credit of $327 when opening this portfolio).
  • Best-case scenario ("Net Potential Return"): a gain of 23.29%.
  • More likely scenario ("Expected Return"): a gain of 7.69% (this takes into account that actual returns in our tests have average 0.3x potential returns).

Initial Impact Of Trading Costs And Option Spreads

Recall that the user entered $250,000 when creating this portfolio. Note the initial value here of $248,275.

Image via Portfolio Armor. Our subscriber is down $1,725 due to trading costs being deducted and the difference between where he placed his option trades, in our conservative assumption (at the worst ends of the spreads) and where we value them (at their intrinsic value or the midpoint of their bid-ask spread, whichever is higher). Here's an expanded look at the hedge on NVDA, to make this clearer.

Image via Portfolio Armor. Note the cost of the put options, at the ask, was $3,450. Note that in the table below the chart, the put options are valued at $3,437.50 instead, which was the midpoint of the bid-ask spread.

You can see, too, that the hedge for NVDA expires in September. That's true of CENX as well, but the three positions had hedges expiring in August. Keep that in mind as you look at the value of the portfolio as of Friday, below.

Image via Portfolio Armor. As you can see above, only NVDA and CENX remain in the table; the system exited the other three positions in mid-August; their ending values, minus trading costs, appear now as part of the cash total.

Note, too, that value of the NVDA put options as of Friday: $7.50. Their intrinsic value was zero, and there was an ask price of 3 cents and a bid price of zero. So they were valued at the midpoint of that, 1.5 cents. Since there were 5 contracts, and each contract represents 500 shares: 500 ($0.015) = $7.50.

On the other hand, the call option value for NVDA was $17,730. That represents the intrinsic value of the calls, which was greater than the midpoint of the bid-ask price on Friday. Recall from the expanded view of the NVDA collar that the strike price of the calls was $135. Since NVDA closed at $170.46 on Friday, the intrinsic value of those in-the-money calls was $170.46 - $135 = $35.46. Since there are 5 call option contracts representing 500 shares of NVDA: 500 x $35.46 = $17,730. That value belongs to the owner of the call options the user sold, so we deduct it from the NVDA position.

Conclusion

Between the initial hedged portfolios are system presents, which detail each underlying position and option, along with their respective amounts and prices, and our new tracking tool, which calculates the values of each underlying position and hedge, and the portfolio in aggregate, at each point in time, we are now able to offer you a complete transparency into our performance. This first portfolio has more than doubled the return of the SPDR S&P 500 ETF (SPY) so far, after trading costs (13.74% versus 5.05%), and did so while limiting the user's risk to a drawdown of no more than 16%.

We don't expect every portfolio of ours to lap the index like that, particularly as the more tightly hedged portfolios will have positive hedging cost as a drag on returns in an up market. But we are encouraged by this one. If subsequent performance remains strong, we intend to raise the membership fee of Bulletproof Investing. Either way, we intend to eliminate the annual membership discount for a different reason. So if you think our approach makes sense, you may want to consider our annual membership discount on the current price while both are still available.

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.