The elevated valuation of the stock market has clearly caused many investors to consider finding a way to hedge their portfolios, and this interest in hedging will undoubtedly grow as investors look at the effect of the recent sell-off on their portfolios. Caution at the present moment is understandable - and a calculated caution is always a good idea - but is there really an effective way to hedge?
After 60 years of investing and following the markets, I have come to believe that the basic answer is a simple no. Over the years, I have tried most of the favored approaches, most often by selling calls against some positions, but the outcome has been mixed. (I have rarely bought puts to hedge because they are on the wrong side of an instrument, which is a wasting asset because of time decay.) The call writes have probably been profitable on balance over a long period, but they have sometimes had highly undesirable results.
The approach I have come around to is to hold a substantial cash reserve. I begin to ramp up my cash position when the market seems to me, by many indicators, to be becoming expensive. I increase my cash reserve progressively as valuations increase or, more specifically, when I find it hard to find things to buy at a reasonable price.
To increase my cash position, I let cash build up when I have new money to add, I sell everything that I hold at a loss, usually in the last couple of months of the year, and last, reluctantly, I sell positions with capital gains that have wildly overshot my estimate of their fair value.
By one means or another, I allow my cash reserve to build up until the equity part of my portfolio is matched by cash. I don't go beyond 50% cash, because of the tax problem that comes with selling winners but also because I never let myself think I know what the market is going to do to that degree.
When you get to 50-50, only half of whatever happens to the market is going to happen to you. For those of you familiar with the Kelly Criterion, it's sort of like half-Kelly betting. You avoid Gambler's Ruin (being right in the long run but susceptible to being wiped out first by a piece of bad luck). So don't get me wrong: I don't like to hold a lot of cash, but I do it when my sense of opportunity doesn't warrant taking high risk.
Put it this way: hedging with cash is sort of like the definition Churchill is said to have given for democracy ("the worst form of government except for all the others that have been tried"). That's cash as a hedge. It's the worst way of hedging except for all the others that have been tried. Let me explain.
The Problem With Active Hedging
The question of cash versus active hedging happened to be on my mind about ten days ago when this piece by Mad Hedge Fund Trader turned up among my Articles By People You Follow. I get a kick out of Mad Hedge Fund Trader (John Thomas) and read everything he writes. From the asides in his pieces, he seems to have been that character who is standing in the background at important turns in history. I sometimes wonder if his image hovers behind Roosevelt, Churchill, and Stalin at Yalta, and can imagine him whispering into his chum Janet Yellen's ear last week that she should stick it to Wells Fargo (NYSE:WFC) on her way out the door.
Anyway, Mad Hedge Fund Trader is always amusing, and his views from fifty thousand feet are often very insightful. I chose his piece recommending a portfolio hedge not because it is bad, but because it is quite reasonable and simple as hedges go. And he's not alone, by the way. This morning Goldman came out with the same general advice.
Before recommending a hedge, Mad Hedge Fund Trader dismissed using the volatility index (VIX) as a hedge, citing the contango of future contracts (term structure implying higher future volatility). I agree wholeheartedly. I don't like volatility as a hedge, period. I suspect he would also agree with me about double or triple-negative ETFs which are structured for squirrelly results at best and produce nothing like the results they promise.
What Hedge Fund Trader recommends is buying a June 2018 out-of-the-money put on the S&P 500 (SPY) - the strike price just about 11% out of the money. At the time of his writing, SPY was trading at $279.64. Also, at the time of his writing, you could hedge a $100,000 portfolio with $1,000 by buying 100 of the June 18, 2018, puts at a strike price of $250. Lower in the article, he said that you might offset $764 of that cost by selling the same number of $295 same date calls. Unless you do that, you have surrendered 1% of your portfolio for the hedge.
Now, let's have a look at the implications of this hedge. To start with, the put hedge at expiration has a breakeven point of $247.50. What does that mean? That means that the SPY has to have fallen about 32 points at expiration just to recapture the cost of the put. That's about 11 1/2 percent. It's only below the price of $247.50 that the put has hedged your portfolio at all.
The problem is twofold. No one has any idea how big the current (or next) correction will be. The most common dips are 5%, long overdue, or 10%, also pretty long overdue. To get meaningful one-for-one hedging (one point increase in put value for one point decline), the market would have to be down something like 20%. Then, you would avoid about 43% of the decline. The trouble is that 20% declines are much less frequent than 10% declines.
Then, there is the problem of time. If the market drops less than 10% and June 18 arrives, your puts expire worthless and you have given up 1% of your capital. Of course, this is not what Mad Hedge Fund Trader has in mind. What he is thinking of is a much earlier jump in the price of puts as the market gets whacked and volatility increases. It may well happen, but it is crediting yourself with a great deal of forecasting skill or reflecting a high level of short-term terror. Just in case the market arrives at June 18 with the price more or less unchanged, what do you do? Buy another round of puts?
Let me say, though that in the short term the puts have done pretty well. Last Friday, January 15, the puts jumped 44.12% on the day, a bit over a buck. That's a nice one-day gain. You were up more than $400. On the other hand, the SPY was down over 2%. Your portfolio was down over $2000. You were far from being hedged one-to-one. In essence, the puts were a side bet - a speculation - rather than a hedge. Want to speculate? Help yourself.
Then, there are taxes. Any profits on options are treated as short-term capital gains. So, let's go back to the successful hedge for a drop exceeding 11 1/2%. Take that number of one-for-one offsetting gain for further market drop and whack it by your marginal Federal/state tax rate.
The Hedge Versus Cash
The downside protection of cash is pretty much obvious. Let's take the performance of a $100,000 portfolio with 10% cash in a 10% correction. The downside of that portfolio is 10% of the $90,000 invested, or $9,000. The protection versus full investment is $1,000. The put hedge saves you zero.
Larger corrections? The breakeven is about a 13% decline. After that, the numbers begin to be much better for the put compared to a 10% cash position. Declines seriously above 13% are not frequent, but they can certainly happen. If that's your worry, you might ramp up cash well over 10%. A serious increase in cash to 20% or 30% creates a much higher hurdle for the breakeven point.
And that's before the taxes you have to pay on the gain in the SPY put. If using a muni fund to hold cash, you can get around 1% after most state taxes. And bear in mind the time factor. If the correction comes and goes, or the major correction doesn't come until July, then what? You are left with tough decisions.
What about making the hedge cheaper by selling the calls? Ask yourself this: what if the market corrects five or ten percent at this point and then continues the upward march at the recent pace and closes above $295. That would have been only a little more than 5% above the original price of $279.64. You're giving up any gains beyond that point. But wasn't the purpose of the hedge to hang in there for the gains and sacrifice a little for protection?
How about just hanging in there for all future gains? The hedge caps your upside at 5%; you now have $105,000. Suppose the market rises ten percent. A 10% cash position takes you up to $109,000 and rapidly pulls away after that. Is this less probable than a 13% decline? Perhaps, but I like to start with the math and proceed to opinions second.
Bonds, by the way, used to perform this function in portfolios and will again in the future, but they currently offer very little beyond the rate that can be achieved by laddering out as far as 2-Year T-Bills. The flat yield curve makes longer durations relatively unattractive compared to cash and near cash. And currently, the main risk of bonds is likely to be correlated to stock risk.
The Pros And Cons Of Cash
The main problem with cash is that it doesn't earn much, and almost every other asset class has beaten its return over most fairly extended periods going back hundreds of years. On the other hand, cash has started to earn a little more than it has in earned in recent history, a fact I noted in this piece and which was also treated in this excellent piece by Tipswatch, with his usual astuteness and attention to detail. Implicit in both our pieces is that cash is no longer an asset to be dismissed and neglected. The narrowing expected returns between stocks and cash improve the argument in its favor for reducing portfolio risk.
Cash and near cash (short but not zero duration) may afford up to 2% return currently (in the above piece I mentioned a ladder of 8-month, 16-month, and 2-year Treasury bills), and the rates are likely to trend higher for the next year or two until whatever moment the Fed feels that it is time to start cutting them again. Meanwhile, the equity market will...I have no idea what it will do in the short term, and I don't think anyone else does either.
I do believe, based on valuation, that the market may have surprisingly meager returns over significantly longer periods, but the way this unfolds and the amount of time until the valuation problem really asserts itself are entirely opaque to me. Maybe we've just started a correction of some size, but there's no way to know. That's the major problem with hedges.
The problem with buying puts is grounded in their time decay. I may think the market has a few whacks ahead of it, but I have no way of knowing if they will happen soon enough for a put to make sense. I have tried the kind of hedging that puts time decay on your side, selling in-the-money calls against stocks I hold with large capital gains, but my success has been uneven. The worst thing is having the calls assigned before expiration (my intent has been to buy them back about a week before), thus losing the stock and paying the cap gains taxes after all. The second time this happened to me I put a post-it note on my desk saying No More Hedging With Call Writes!.
The way to frame the rationale for a large cash position is that it is the opposite of using leverage by buying on margin. In pricey markets like this one, the reverse strategy is to de-leverage and reduce risk. It keeps you from scouring the market for "safe" sectors (I'm not sure there are any) and lets you hold good companies with large capital gains which you wouldn't buy at the present price but also wouldn't sell. This describes my portfolio, which I still think contains the best things to own in this market but none of which I would buy more of at the current price.
About three years ago, I began to let cash build up in my account. I started selling any positions with losses or small gains. I bought new positions only when I sold old ones (banks replacing all REITs, on a major scale, in the middle of 2016) and paid some taxes on the REITs, not in IRAs. I trimmed my bank position by selling Citigroup (NYSE:C) in an IRA account in December of 2017. A couple of weeks ago, I bit the bullet and sold my most overpriced holding, NVR (NVR), after writing this piece on the difficulty of the decision. It had doubled in a year, and my portfolio as a whole had moved away from the allocation I target.
Holding 45-50% cash hasn't really hurt my returns compared to the S&P 500. My portfolio roughly matched fully the S&P index (fully invested with dividends) in 2016 and trailed with 17% to the S&P's 21% last year. The drivers of the returns were a heavy concentration in Berkshire Hathaway (BRK.A)(BRK.B), the REITs (until I sold them) and then banks, property and casualty insurance companies, and several industrials. All were cheap when I bought them and strongly leveraged to economic growth.
That being said, these were exceptional years - probably my best of a lifetime in risk-adjusted returns - and I recognize that they are unlikely to be repeated. I expect my best results in the future may come from a cash position that smoothes the effect of market hiccups and enables me to buy things that become cheap. Maybe the biggest virtue of a large cash position is that it has enabled me to hold my idiosyncratic and concentrated portfolio with peace of mind.
Meanwhile, there's another guy who, whatever he says on CNBC, seems to validate this view with his actions. His name is Buffett, and he has allowed the cash position at Berkshire Hathaway to mount up to well over a hundred billion and climbing, held in Treasury Bills. At this moment that cash is about 40% of the combined value of his total liquid portfolio of cash and publicly traded stocks. Just saying.
Is there another approach besides cash and active hedging? Of course. In town for his 25th birthday, my stepson asked me how to invest the 401(k) offered by his new company. I told him just to put two-thirds in the Vanguard Total Stock Market Index (VTSMX) and one-third in the FTSE All World ex-US Index (VFWAX). I explained that he would probably suffer a few bumps and look silly for a few periods of the next five or ten years but that if anything made that allocation do badly over his working career, it would be because of problems that overshadowed things like investment returns.
If you're my stepson's age or a bit older, time works in your favor and is the only portfolio defense you need.
A Necessary Postscript
Wow! I knew while I was writing this that the market was in for a rough day, but I just glanced up and noticed that the market was being clobbered, about 5% down with 45 minutes or so to the close. Be sure that you know that nothing in this article suggests going out and creating a large cash position at this moment. If it gets worse, it's all the more a good time to have a cool head. I will say that the SPY put I discussed in the article is still far from being in the money, but its chances may have improved slightly. My own approach is in the nature of a longer term policy and is not much affected by this day.
But let me tell you something about the psychological/emotional effect. I called my wife at the office to tell her the market was having a bad day, but she had no reason to worry. Having a solid investment policy - which for me involves a large cash position in highly priced markets - allows the kind of distance to make good decisions, which are often decisions to do nothing, be at peace, and enjoy your everyday life. Best to all readers, my hopes that you are keeping cool heads and not suffering market anxiety. Comment, ask questions, and I will do my best to answer.
Disclosure: I am/we are long C, BRK.B.
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.