Summary Two alternatives for airline investors are to pick individual airline stocks or to purchase shares of an airline industry ETF. The ETF ameliorates stock-specific risk via diversification, but allocates only small amounts to some of the most promising stocks. We present a 3rd alternative: using the hedged portfolio method to create a concentrated portfolio of top airline stocks that strictly limits stock-specific as well as other kinds of risk. A Third Way Between JETS and Individual Airline Stocks The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down. –Warren Buffett It’s customary to quote Warren Buffett’s bearishness on the industry when writing about airline stocks, and the Buffett quote above, from the 2007 Berkshire Hathaway (NYSE: BRK.B ) shareholder letter , is my favorite. Seeking Alpha contributor Harm Elderman chose another good one in his recent article on the US Global Jets ETF (NYSEARCA: JETS ) (“Time To Re-Examine JETS: The Airline ETF”). Elderman’s article is worth reading in full, but this graphic he included does a great job of laying out the way the JETS ETF is diversified. That diversification, as Elderman notes, offers an interesting tradeoff. Elderman points out that, due to the way JETS is structured, particularly in the second point in the graphic above, his top airline pick at midyear, Hawaiian Holdings (NASDAQ: HA ), as a second-tier domestic airline, only gets a 4% allocation in the ETF. So a JETS investor would have gotten relatively little benefit from HA’s 35% year-to-date performance. On the other hand, had HA done as poorly as another airline mentioned in Elderman’s article, Avianca Holdings (NYSE: AVH ), which is down nearly 67% year-to-date, its impact on JETS’ performance would have been similarly limited. Nevertheless, as Elderman points out, JETS has outperformed the SPDR Dow Jones Industrial Average ETF (NYSEARCA: DIA ) year to date, up 6.13%, as of Tuesday’s close, versus DIA, which was down 1.24% over the same time frame, so it may be worthy of consideration for investors looking for exposure to the airline industry without incurring the risk of picking a handful of airline stocks on their own. In this article, though, we’ll look at a third way of investing in airline stocks, one that can give us bigger exposure to stocks like HA, but with less risk than owning the ETF. When Stocks Can Be Safer Than An ETF It may seem counterintuitive that owning a handful of airline stocks could be safer than owning an ETF that holds dozens of them, but that can be the case when you hold those stocks within a hedged portfolio. Although JETS ameliorates stock-specific risk via diversification, it’s still subject to industry risk and systemic, or market risk. You can strictly limit your potential downside due to any of those risks with the hedged portfolio method . Below, we’ll show how to use that method to construct a concentrated portfolio of airline stocks using JETS’ top holdings as a starting point, for an investor who is unwilling to risk a drawdown of more than 20%, 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 30% decline will have a chance at higher potential returns than one who is only willing to risk a 10% drawdown. In our example, we’ll be splitting the difference and using a 20% threshold (less than a third of the drop AVH shareholders have experienced so far this year). Constructing A Hedged Portfolio We’ll recap the hedged portfolio method here briefly, and then explain how you can implement it yourself using JETS’ 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 potential 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 airline industry stocks; instead, we’d consider a much broader universe of stocks. But since we’re concerned with airline stocks here, we’ll start with the top holdings of JETS. To quantify potential returns for JETS’ top holdings, you can sign up for Harm Elderman’s premium research via Seeking Alpha’s Marketplace. Alternatively, if you are impecunious and willing to put yourself at the mercy of Wall Street’s sell side analysts, you can use their consensus price targets as a starting point for your estimates, adjusting it based on the time frame you’re using and whether you think it is overly optimistic or not. For example, via Nasdaq, here is the analysts’ 12-month consensus price target for Hawaiian Airlines: 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-20% 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 JETS, 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 1.93x higher. In this case, the net potential returns were > 1.93x higher when hedged with optimal collars in each case. Here’s a closer look at the optimal collar edge on HA: This optimal collar is capped at 12.06% because that’s the potential return the site calculated for HA. The idea is to have a shot at capturing that, while offsetting the cost of hedging by selling someone else the right to buy HA if it goes higher than the site expects it to. As you can see at the bottom of the image above, the cost of the put protection on HA was $3,420, or 5.41% as a percentage of position value. However, if you look at the image below, you’ll see that the income from selling the call leg of this collar was $2,610, or 4.13% as a percentage of position value. So the net cost of the collar was $810, or 1.28%.[i] Note that, although the cost of this hedge was positive, the overall cost of hedging the portfolio was negative . 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 what happened to a hedge on Sketchers (NYSE: SKX ) after that stock plummeted 31%. [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. The same is true of the other hedges in the portfolio, the costs of which were calculated in the same conservative manner.