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Summary During the average 6-month period over the last 10 years, the Dow-tracking ETF DIA gained 3.98%. DIA shareholders suffered a 38% decline during one of those 6-month periods. A hedged portfolio of Dow component stocks, such as the one shown below, can offer a higher expected return with less than half the drawdown risk. Although cost is a concern when hedging, in our example, the hedged portfolio has a negative cost. Risk Versus Return For The Dow-Tracking ETF Although not as widely-traded as ETFs tracking the S&P 500 and the Nasdaq, according to the ETF Database , the SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA ) is among the top-40 ETFs by average trading volume over the last 3 months, and has assets under management of over $11.5 billion, so it holds a place in the portfolios of a lot of investors. Any of those investors who owned DIA in late 2008 and early 2009 saw the ETF drop about 38% within a six-month period between August of 2008 and February of 2009. During the average six-month period over the last ten years, though, DIA investors had a respectable total return of about 3.98%. But as we’ll show below, by using the hedged portfolio method to invest in some of DIA’s top holdings, an investor can get a higher expected return over the next six months while risking a drawdown less than half as large as the one mentioned above. When Stocks Can Be Safer Than An ETF It may seem counterintuitive that you can be exposed to less risk by holding a handful of Dow components than by holding the ETF that owns all of them, but that can be the case when you own those stocks within a hedged portfolio. Although a diversified limits the idiosyncratic risk of owning individual stocks, it doesn’t limit market risk (DIA isn’t as diversified as some ETFs, as it has about half of its assets in its top-10 holdings). But a hedged portfolio limits both. Below, we’ll show how to construct a hedged portfolio out of DIA top holdings for an investor who is unwilling to risk a drawdown of more than 19%, and has $500,000 that he wants to invest. First, though, let’s address the issue of risk tolerance, and how it affects potential return. Risk Tolerance and Potential Return All else equal, with a hedged portfolio, the greater an investor’s risk tolerance — the greater the maximum drawdown he is willing to risk (his “threshold”, in our terminology) – the higher his potential return will be. So, we should expect that an investor who is willing to risk a 29% decline will have a chance at higher potential returns than one who is only willing to risk a 9% drawdown. In our example, we’ll be splitting the difference and using a 19% threshold (half of the 38% drawdown DIA investors experienced in 2008-2009). Constructing A Hedged Portfolio We’ll recap the hedged portfolio method here briefly, and then explain how you can implement it yourself using DIA’s top holdings as a starting point. Finally, we’ll present an example of a hedged portfolio that was constructed this way with an automated tool. The process, in broad strokes, is this: Find securities with relatively high potential returns. Find securities that are relatively inexpensive to hedge. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns). Hedge them. The potential benefits of this approach are two-fold: If you are successful at the first step (finding securities with high expected returns), and you hold a concentrated portfolio of them, your portfolio should generate decent returns over time. If you are hedged, and your return estimates are completely wrong, on occasion — or the market moves against you — your downside will be strictly limited. How to Implement This Approach Finding Promising Stocks If we were looking for securities with the highest potential returns, we wouldn’t limit ourselves to just Dow components; instead, we’d consider a much broader universe of stocks. But since we’re concerned with Dow stocks here, we’ll start with the top holdings of DIA. To quantify potential returns for DIA’s top holdings, you can check Seeking Alpha Pro for articles that offer price targets for the stocks, or you can use sell-side analysts’ consensus price targets for them and then convert those to percentage returns from current prices. For example, via Nasdaq , this is the 12 month consensus price target for Dow component and top-10 DIA holding Goldman Sachs (NYSE: GS ): You can use that consensus price target as a starting point for your estimate, adjusting it based on the time frame you’re using and whether you think it is overly optimistic or not. In general, though, you’ll need to use the same time frame for each of your potential return calculations to facilitate comparisons of potential returns, hedging costs, and net expected returns. Our method starts with calculations of six-month expected returns. Finding inexpensive ways to hedge these securities Our method attempts to find optimal static hedges using collars as well as protective puts going out approximately six months. Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-19% decline over the time frame covered by your potential return calculations. And you’ll need to calculate your cost of hedging as a percentage of position value. Select the securities with highest net potential returns When starting from a large universe of securities, you’d want to select the ones with the highest potential returns, net of hedging costs; you can do the same here, starting with the top holdings in DIA, but, in any case, you’ll at least want to exclude any of them that has a negative potential return net of hedging costs. It doesn’t make sense to pay X to hedge a stock if you estimate the stock will return Scalper1 News
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