AT&T celebrates its 5G speed (image via AT&T's Twitter page).
Building A Hedged Portfolio Around An AT&T Position
In 2017, I presented a hedged portfolio built around an AT&T (T) position. That portfolio was designed to last six months, and six months later, it had hit it out of the park, outperforming my site's best-case scenario and the SPDR S&P 500 ETF (SPY), as you can see in the chart below.
Last August, I presented another hedged portfolio around AT&T, though I wrote at the time that it was unlikely to be able to replicate last year's extraordinary performance. Like the 2017 AT&T hedged portfolio, this one was designed to last six months. When we checked on the portfolio three months in, we noted lightning hadn't struck twice: The portfolio was down, albeit not down as far as SPY.
The August 2018 AT&T portfolio as of November.
Let's see how the portfolio finished at the end of six months. First, a reminder of how the portfolio was constructed and what it consisted of.
Constructing The August 2018 AT&T Hedged Portfolio
We used the Hedged Portfolio Method to build a concentrated portfolio around AT&T in August starting with these premises:
- You had $100,000 to invest.
- You were unwilling to risk a drawdown of more than 8% over the next six months, so you wanted to be hedged against any decline greater than that.
- You wanted to invest in a handful of names, including AT&T, with a goal of maximizing your potential return net of hedging costs.
Here's a recap of the steps involved, if you wanted to do this manually.
Step 1: Estimate Potential Returns
The goal of this step was to find names that had the potential to generate high total returns to include alongside AT&T - whether those returns were to come partly from dividends or not wasn't relevant (tax considerations aside). Our site, Portfolio Armor, calculated its own potential returns by analyzing adjusted price history (which takes into account dividends) and option market sentiment, but you could have derived yours from Wall Street price targets or the price targets given by Seeking Alpha contributors you follow. Your initial universe could have been as big as Portfolio Armor's (the ~4,500 stocks and Exchange-Traded Products with options traded on them in the U.S.), or something smaller, such as the Dow 30.
Step 2: Calculate Hedging Costs
Since you were going to hedge, gross potential returns were less important to you than potential returns net of hedging costs. To figure those out, you needed to figure out the optimal or least expensive way to hedge each name. We wrote about how to find optimal hedges here. For this example, you would have been looking for the cost of hedging against declines of 8% or greater. In general the lower the decline you're looking to hedge against, the narrower the list of names your able to use. AT&T tends to be hedgeable against low decline thresholds, which is partly why we used a low threshold here.
Step 3: Rank Names By Net Potential Return
For each of the names in your initial universe that has a positive potential return, you would have subtracted the hedging cost you calculated in Step 2 to get a net potential return.
Step 4: Buy And Hedge
Here, you would have bought and hedged a handful of names that had the highest potential returns net of hedging costs. The automated approach we used included a fine-tuning step to minimize your cash, but these four steps were the basics.
The August AT&T Hedged Portfolio
Using the process outlined above, this was what Portfolio Armor's automated hedged portfolio construction tool presented us on Aug. 9:
In addition to AT&T, the site included Broadridge (BR), Callaway Golf (ELY), and Morningstar (MORN) as primary securities, based on their net potential returns when hedged against >8% declines, and their share prices being low enough that it could include round lots of each of them in a $100,000 portfolio. The site attempted to allocate roughly equal dollar amounts to each of those names, but rounded down the dollar amounts to make sure it had round lots of each stock.
In its fine-tuning step, it selected Box (BOX) to absorb cash left over from the process of rounding down the primary securities. BOX was hedged with an optimal collar with a cap set at the seven-day (annual) yield of the Fidelity Government Cash Reserves money market fund (FDRXX) at the time. The hedging cost of this was negative: The idea here was to get a shot at a higher return than cash while lowering the overall hedging cost of the portfolio and limiting your downside risk in accordance with your risk tolerance.
Performance Of The Underlying Securities
This is how the underlying securities in the hedged portfolio performed over the next six months, unhedged:
AT&T was the second best performer here, being down 6.17%. The chart above illustrates why you wouldn't want to invest in such a concentrated portfolio without hedging. Assuming, for simplicity's sake, your portfolio was equally weighted, you'd be down nearly 15.6% so far.
Performance Of The Hedged Portfolio
Here's how the hedged portfolio has performed over its full duration.
Although the underlying securities were down an average of 15.6%, the hedged portfolio was only down 4.25%, while SPY was down 4.12% over the same time frame. Although this portfolio underperformed SPY by 13 basis points, as you can see from the chart, it was a less stressful ride from early December to mid-January than SPY. At its nadir on Christmas Eve, SPY was down 16.93% from Aug. 9, while this portfolio was down 5.81%.
Heads You Win, Tails You Don't Lose Too Much
In 2017, as you can see in the first chart above, the AT&T hedged portfolio did very well, albeit mainly due to the inclusion of Align Technology (ALGN) and IPG Photonics (IPGP): It was up more than 26% (Align Technology, a winner in 2017, was a loser in the second half of 2018). The August 2018 AT&T portfolio ended up down 4.25%. The relation between the upside in the 2017 AT&T portfolio (+26%) and the downside of the 2018 one (-4.25%) exemplifies the "heads you win, tails you don't lose too much" approach of the hedged portfolio method.
To be transparent and accountable, I post a performance update for my Bulletproof Investing service every week. Here's the latest one: Performance Update - Week 63.
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.