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Summary An investor can “bullet-proof” his portfolio while maximizing his expected return using the hedged portfolio method. When creating a hedged portfolio, you can start from scratch or start with a list of stock picks. We explore the second method here. The stock picks we start with are ones rated “A+” by S&P Capital IQ for growth and stability of earnings and dividends. We provide a sample hedged portfolio of “A+” stocks designed for an investor unwilling to risk a drawdown of more than 14%. Growth Investing versus Value Investing The idea of buying a stock for less than its ” intrinsic value ” has an innate appeal to value investors, but, as leading buy-and-hold investing blogger Eddy Efenbein suggested in a recent quip, not everyone is cut out for it: Give a man a value stock and he’s invested for a day, but teach a man value investing and he’ll be in anxiety-ridden mess for life. – Eddy Elfenbein (@EddyElfenbein) September 24, 2015 Unlike bargain-shopping value investors, growth investors are willing to pay more for a stock, in return for the prospect of higher future earnings growth. But that doesn’t necessarily eliminate anxiety. As with any style of stock investing, with growth investing, you face two kinds of risks: idiosyncratic risk , the risk of something bad happening to one of the companies you own, and market risk , the risk of your investments suffering due to a decline of the market as a whole. Two Ways of Limiting Stock-Specific Risk One way to limit stock-specific risk is via hedging; another way is via diversification. In a previous article (“How to Limit Your Market Risk”), we discussed ways to limit market risk for a diversified portfolio. In this post, we’ll look at how to “bulletproof” a concentrated portfolio of growth stocks using the hedged portfolio method . In that method, you limit both stock-specific and market risk via hedging. First, we’ll need a list of growth stocks to start with. For that, we’ll use a screen devised by the research firm S&P Capital IQ . A+ Stocks with High Projected Growth The goal of this screen is to find stocks likely to extend their superior historical earnings and dividend growth records. It uses two criteria: Forward annual earnings growth estimates of 12% or better over the next 3-5 years. An S&P Capital IQ Earnings and Dividend Rank of A+, which means a 10-year history of high growth and stability of earnings and dividends. On Wednesday, Fidelity’s screener identified seven stocks meeting those S&P Capital IQ criteria: Advance Auto Parts (NYSE: AAP ) CVS Health (NYSE: CVS ) Echolab (NYSE: ECL ) Ross Stores (NASDAQ: ROST ) Tupperware Brands (NYSE: TUP ) UnitedHealth Group (NYSE: UNH ) Walt Disney Co. (NYSE: DIS ) We’ll use those stocks as a starting point to construct a “bulletproof”, or hedged portfolio for an investor who is unwilling to risk a drawdown of more than 14%, 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 24% decline will have a chance at higher potential returns than one who is only willing to risk a 14% drawdown. Constructing A Hedged Portfolio We’ll outline the process here briefly, and then explain how you can implement it yourself. 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 high potential returns (we define potential return as a high-end, bullish estimate of how the security will perform). 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 twofold: If you are successful at the first step (finding securities with high potential returns), and you hold a concentrated portfolio of them, your portfolios 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 In this case, we’re going to start with the stocks generated by the A+ high growth screen. To quantify potential returns for these stocks, you can, for example, use analysts’ price targets for them and then convert these to percentage returns from current prices. 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 potential returns. Our method starts with calculations of six-month potential returns. Finding inexpensive ways to hedge these securities Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-14% decline over the time frame covered by your potential return calculations (our method attempts to find optimal static hedges using collars as well as protective puts going out approximately six months). And you’ll need to calculate your cost of hedging as a percentage of position value. Selecting the securities with highest net potential returns In order to determine which securities these are, out of the list above, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you’ll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and exclude any security that has a negative potential return net of hedging costs. Fine-tuning portfolio construction You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs, so if you’re going to include a handful of securities from the sort in the previous step and you have a relatively small portfolio, you’ll need to take into account the share prices of the securities. Another fine-tuning step is to minimize cash that’s left over after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won’t need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method searches for what we call 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. You could use a similar approach, or you could simply allocate left over cash to one of the securities you selected in the previous step. Calculating Expected Returns While net potential returns are bullish estimates of how well securities will perform, net of their hedging costs, expected returns, in our terminology, are the more likely returns net of hedging costs. In a series of 25,412 backtests over an 11-year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns. An Automated Approach Here we’ll show an example of creating a hedged portfolio starting with S&P Capital IQ’s A+ growth stocks using the general process described above, facilitated by the automated hedged portfolio construction tool at Portfolio Armor . In the first step, we enter the ticker symbols in the “Tickers” field, the dollar amount of our investor’s portfolio (500000), and in the third field, the maximum decline he’s willing to risk in percentage terms (14). In the second step, we are given the option of entering our own return estimates for each of these securities. Instead, in this case, we’ll let the site supply its own potential returns. A couple minutes after clicking the “Create” button, we were presented with the hedged portfolio below. The data here is as of Wednesday’s close. Why These Particular Securities? The site included all of the entered securities for which it calculated a positive potential return, net of hedging costs. In this case, that turned out to be all of them except TUP. In its fine-tuning step, Portfolio Armor added Facebook (NASDAQ: FB ) as a cash substitute. Let’s turn our attention now to the portfolio level summary. Worst-Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before their hedges expired, the portfolio would decline 13.8%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -1.98%, meaning the investor would receive more income in total from selling the call legs of the collars on his positions than he spent buying the puts. Best-Case Scenario At the portfolio level, the net potential return is 5.76% over the next six months. This represents the best-case scenario, if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 2.02% represents a conservative estimate, based on the historical relationship between our calculated potential returns and backtested actual returns. How to Get a Higher Expected Return The site calculates potential returns using an analysis of price history and options sentiment, and, according to those metrics, didn’t consider the stocks we entered “A+”. If you disagree with the site’s potential returns for these stocks, you can enter your own estimates for them. Alternatively, you could decide not to enter any ticker symbols, and let the site pick its own securities. If you had done that on Wednesday using the same dollar amount ($500,000) and decline threshold (14%), the hedged portfolio generated would have had a net potential return (best case scenario) of 16%, and an expected return (more likely scenario) of 4.8%. Each Security Is Hedged Note that each of the above securities is hedged. Facebook, the cash substitute, is hedged with an optimal collar with its cap set at 1%, and the remaining securities are hedged with optimal collars with their caps set at each underlying security’s potential return. Here is a closer look at the hedge for UnitedHealth: UnitedHealth is capped here at 4.62%, because that’s the potential return Portfolio Armor calculated for it over the next several months. As you can at the bottom of the image above, the cost of the put protection in this collar is $1,600, or 2.6% of position value. But if you look at the image below, you’ll see the income generated from selling the calls is $2,700, or 4.38% of position value. So, the net cost of this optimal collar is negative.[i] Possibly More Protection Than Promised In some cases, hedges such as the ones in the portfolio above can provide more protection than promised. For an example of that, see this instablog post on hedging the iPath S&P 500 VIX ST Futures ETN (NYSEARCA: VXX ). [i]To be conservative, this optimal collar shows the puts being purchased at their ask price, and the calls being sold at their bid price. In practice, an investor can often buy the puts for less (i.e., at some point between the bid and ask prices) and sell the calls for more (again, at some point between the bid and ask). So the actual cost of opening this collar would have likely been less (i.e., an investor would have likely collected more than $1,100 when opening this hedge). Scalper1 News
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