Tag Archives: david-pinsen

How To Limit Your Market Risk

Summary As the bull market has continued, so have predictions about its demise. We note the latest one, and the problem presented by such predictions. We discuss ways to limit market risk and describe one method. We show an example of that method using an automated approach. The Latest Bearish Prediction As the current bull market has powered on, there has been no shortage of predictions of its eventual end. The latest such prediction appeared in an article by James Fontanella-Khan and Abash Massoudi in Saturday’s Financial Times (“Value of megadeals this year beats dotcom-boom record to reach $1.2tn”). The authors detailed this year’s record volume of mergers and acquisitions and then warned, But if history is anything to go by, activity might well be at a peak. Data from Dealogic show that sustained deal-making cycles from 1997 to 2000 and from 2005 to 2008 were followed by sharp stock market falls The Problem Presented by Bear Market Predictions The problem presented by bear market predictions such as the one above is what to do with the information, particularly when we’re not given a time frame when we can expect the bear market to begin. If you got out of the market at the first one of these predictions, you would have missed most of the current bull market. On the other hand, if you do nothing to protect yourself, and the prediction comes to pass soon, you may regret your inaction. A solution to this problem is to stay invested, but take steps to limit your market risk. First, we should clarify the difference between market risk and idiosyncratic risk. Market Risk versus Idiosyncratic Risk Idiosyncratic risk , in a portfolio comprised of common stocks, can also be thought of as stock-specific risk: it’s the risk of something bad happening to one of your stocks. The chance that one of the companies you own shares of may become the subject of a criminal probe, as Volkswagen (OTCQX: VLKAY ) recently did , is an example of idiosyncratic risk. Idiosyncratic risk can be limited via diversification. Market risk , or systemic risk, is the risk of a decline in the market as a whole, as happens during crashes and bear markets. Since most stocks decline in those cases, market risk can’t be limited via diversification. In order to limit market risk, you need things in your portfolio that will go up in value when everything else is going down. Ways to Limit Market Risk Adding short positions. If you are short some stocks, most likely those will decline in value during a market decline (ideally, you’d want to be short stocks that will decline even if the market doesn’t decline). Seeking Alpha contributor Chris DeMuth, Jr. offered some specific short ideas in an article earlier this month (“Preparing for a Market Collapse, Part II”). One challenge with this is that you may need to allocate a significant percentage of your portfolio to short positions to significantly limit your market risk. If you allocate half of your portfolio to short positions, for example, by investing exclusively in pairs trades, you can eliminate all market risk, and make your portfolio market neutral. This requires some facility with short selling though. Buying inverse ETFs. These include unleveraged inverse ETFs such as ProShares Short S&P 500 (NYSEARCA: SH ), ProShares Short Russell 2000 (NYSEARCA: RWM ), and ProShares Short Dow 30 (NYSEARCA: DOG ), which seek daily returns equal to -1x the returns of the indexes in their names, and leveraged inverse ETFs, such as ProShares Ultra Short S&P 500 (NYSEARCA: SDS ), and ProShares Ultra Pro Short S&P 500 (NYSEARCA: SPXU ), which seek daily returns equal to -2x and -3x, respectively, the daily returns of their indexes. There are two problems with using inverse ETFs to limit market risk. The first is that, because these ETFs react to their underlying indexes in a linear fashion, as in the case with adding short positions to your portfolio, you would need to allocate a significant percentage of your portfolio to them to significantly limit your market risk. The second problem is that, unlike short positions in individual equities, which can potentially produce positive returns in a bull market, inverse ETFs will produce negative returns. So, they will act as a drag on your performance in up markets. For those two reasons, inverse ETFs are not a good way to limit market risk in a typical portfolio (they can be useful tools for market timers, or for those who wish to bet against a particular country or sector, but neither of those scenarios is the subject of this article). Hedging. An advantage of hedging over the previous two methods of limiting market risk is that, because options react to their underlying securities in a non-linear fashion, a small dollar amount allocated to them can protect a much larger underlying security or portfolio. We showed an example of that, with a particular put option on the S&P 500 ETF (NYSEARCA: SPY ), in an article about the August 24th market meltdown. On that day, SPY dropped 4%, the triple-levered inverse ETF SH rose 13%, and that particular put option on SPY (pictured nearby) was up nearly 80%. Hedging can be used to limit market risk in a diversified portfolio, or to limit both market risk and idiosyncratic risk in a concentrated portfolio. We offered an example of the second kind of hedging in a previous article (“Keeping a small nest egg from cracking”). In this one, we’ll look at hedging market risk in a diversified portfolio. Hedging Market Risk If your portfolio is diversified enough so that your idiosyncratic, or stock-specific risk has been ameliorated, you can hedge market risk by buying optimal put options on ETFs that track a relevant index. Puts (short for put options) are contracts that give you the right to sell a security for a specified price (the strike price) before a specified date (the expiration date). Optimal puts are the ones that will give you the level of protection you are looking for at the lowest cost. Step One: Choose A Proxy Exchange-Traded Fund Although mutual funds and some stocks can’t be hedged directly, you can still hedge a diverse portfolio of mutual funds and non-hedgeable stocks against market risk by buying puts on a suitable exchange-traded fund, or ETF. The first consideration is that the ETF will need to have options traded on it, but most of the most widely-traded ETFs do. The second consideration is that the ETF be invested in same asset class as your portfolio. Let’s assume your portfolio consists of large cap U.S. stocks, or mutual funds that invest in them. An ETF you could use as a proxy would be the SPDR S&P 500 Index , which, as its name suggests, tracks the S&P 500 Index. Step 2: Pick A Number Of Shares In order to hedge an equity portfolio against market risk, you would want to hedge an equivalent dollar amount of your proxy ETF. By dividing the dollar amount of your portfolio by the current share price of your proxy ETF, you can get a number of shares of the ETF that you need to hedge. Bear in mind that options contracts cover round lots of shares (generally, a round lot = 100 shares), so if your number of shares includes an odd lot, you can either hedge the next highest round lot of shares, or slightly over-hedge the next lowest round lot of shares. Step 3: Pick a Threshold Threshold, in this context, means the maximum decline in the value of your position that you are willing to risk. Generally, the larger the decline, the less expensive the hedge, and vice-versa. In some cases, a threshold that’s too small can be so expensive to hedge that the cost of doing so is greater than the loss you are trying to hedge. I sometimes use a 20% decline thresholds when hedging equities, an idea borrowed from a comment by fund manager Dr. John Hussman: An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally). Step 4: Find the Optimal Puts Given the time frame over which you are looking to hedge, you’d want to find the put options that would protect you against a greater-than-X% decline (where X is your threshold) at the lowest cost. When doing so, you’d want to keep in mind the cost of the hedge: for example, if you can only tolerate a 20% decline, and there’s a put option with a strike price 20% below the current market price, but it would cost 5% of your portfolio to buy it, then you are actually risking a 25% decline in that case. In most cases, the optimal puts will be out-of-the money, but on occasion they may be in-the-money. An Automated Approach Here we’ll use a hedging app to facilitate finding the optimal puts for an investor with a $787,000 portfolio invested in large cap U.S. stocks, who’s unwilling to risk a decline of more than 20% over the next six months. Steps 1-3: Since our investor is in large cap U.S. stocks, we’ll use SPY as a proxy ETF. So we enter “SPY” in the Ticker Symbol field in the screen capture below. As of Monday’s close, SPY traded at $196.46 per share, so to get our number of shares, we’ll divide 787,000 by 196.46, and enter the result, rounded to the nearest share (“4006”) in the Shares Owned field. In the Threshold field, we enter the largest decline our investor is willing to risk over the next six months, in percentage terms (“20”). Step 4: We tap “Done”, and a few moments later, are presented with the optimal puts: As you can see at the bottom of the screen capture above, the cost of this hedge was $9,960, or 1.27% of our investor’s portfolio value. Note that, to be conservative, the app calculated the cost using the ask price of the puts. In practice, you can often by puts for less (i.e., at some price between the bid and ask), so the actual cost of this hedge would likely have been less. How This Hedge Would Protect Your Portfolio Remember, the reason we picked SPY in this case is because our hypothetical investor’s funds were invested in blue chip US stocks. If those funds drop in value due to a market decline, most likely, the S&P 500 Index will have dropped as well. And if the S&P has dropped, the ETF tracking it, SPY, will have dropped too. If the S&P 500 drops more than 20% — if it drops 20.5%, 30%, 40%, or even more — the put options above will rise in price by at least enough so that the total value of a $787,000 position in SPY + the puts – the initial cost of the puts will have only dropped by 20%, in a worst-case scenario. Hedging A Portfolio Of Stocks And Bonds The example above is simplified in that we’ve assumed our hypothetical investor’s portfolio is entirely invested in equity funds. But what if he had some bonds or bond mutual funds? In that case, we could use a similar process to hedge his portfolio against market risk, except instead of using just one proxy ETF, we’d use one per each asset class. So, for example, if 60% of the investor’s assets were in blue chip US stocks, and 40% in investment grade corporate bonds, we might scan for optimal puts on a number of shares of SPY equal to 60% of the portfolio, and then scan for optimal puts on a number of shares of the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA: LQD ) equal to 40% of the portfolio. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.

There Is No Margin Of Safety

Summary Value investing’s “margin of safety” is illusory: “50 cent dollars” can turn into “50 cent quarters”, or worse. You can use value investing in security selection, but to protect against stock-specific risk, you need to diversify or hedge. An advantage of hedging is that it let’s you concentrate your assets in a handful of stocks you think will do best, while limiting your downside risk. An additional advantage of hedging is that it protects against market risk, which diversification alone does not. We outline a method for creating a hedged portfolio of value stocks, and provide an example. The Margin of Safety in Value Investing One of key terms used in value investing is ” margin of safety “, which refers to difference between a company’s market price and its ” intrinsic value “, as illustrated by the image below (take from the website of Pratt Capital, LLC) Margin of safety was coined by the putative father of value investing, Benjamin Graham, and perhaps the best way to help explain it is quote one of his famous sayings, “In the short run, the market is a voting machine, but in the long run, it’s a weighing machine”. “Voting”, or investor sentiment, drives the market price in the short term, according to Graham, but “weighing”, or recognition of intrinsic value, drives the stock price in the long term. The idea is, essentially, to buy a stock when it’s trading for less than it’s really worth (its intrinsic value), and sell it at some future date when it’s trading at its intrinsic value or higher. The Margin of Safety in Reality Buying a stock for less than your estimation of its intrinsic value and selling it for more later – value investing, in a nutshell – makes perfect sense. What doesn’t make sense is calling that discount between the market price and your estimation of intrinsic value a “margin of safety”, because it isn’t one. Let’s take the simplest case, what Graham referred to as a ” net-net “, a stock trading for less than its net current assets minus its total liabilities. In Graham’s day, these were more common, but you can still find them occasionally today among very small stocks. A stock trading for 50 cents per share with $1 per share in net current assets minus total liabilities would be a classic “50 cent dollar”. A can’t lose proposition, right? Well, not quite. One problem with a so-called 50 cent dollar is that you really don’t know what the net current assets are now ; you only know what they were as of the date they were reported. What if next time the company reports they have only 50 cents in net current assets per share? All else equal (i.e., the same conditions causing it to sell at discount in the past still applying) the share price will tank. And all else may end up being worse. Diversification versus Margin of Safety Of course, Graham knew this, which is why he advocated buying a basket of net-nets, rather than just a few. The basket — i.e., diversification — was his real downside protection against the stock-specific risk of some of his 50 cent dollars turning out to be a 50 cent half dollars, or, worse, a 50 cent quarters. One could argue that value investors today using more subjective measures of intrinsic value based on estimates of future earnings should be even more concerned about downside protection, particularly after some prominent value investing debacles during the last financial crisis. The Limits of Diversification Although diversification protects against stock-specific risk, it doesn’t protect against market risk. When the market tanks, nearly all stocks tank too. We saw this in miniature last month, as we noted in an article published soon after (“Lessons from Monday’s Market Meltdown”), and of course we saw it in 2008 , when stocks were a sea of red across the globe. What offers protection against market risk is hedging. Hedging Against one Kind of Risk or Both You can use a diversified portfolio to limit your stock-specific risk, and hedge against market risk by buying optimal puts on relevant index ETFs. We offered a step-by-step example of that in a previous post (“Protecting A Million Dollar Portfolio”). Alternatively, you can hedge each security you own; if you do that, you are hedging against both market risk and stock-specific risk, so you’ve obviated the need for broad diversification. That enables you to aim for maximizing your potential return with a concentrated, hedged portfolio. You can still use value investing principles to construct that portfolio, but you won’t be relying on an illusory “margin of safety” to protect it. We demonstrate a way of doing that below. 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 25% decline will have a chance at higher returns than one who is only willing to risk, say, a 15% drawdown. For the purposes of this example, we’ll split the difference and create a hedged portfolio designed for an investor with $250,000 who is willing to risk a drawdown of no more than 20%. Constructing A Hedged Portfolio We’ll summarize process the hedged portfolio process here, 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 use a large cap value screen from Zack’s Investment Research, but you could also use value stock ideas from Seeking Alpha or Seeking Alpha Pro . 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 First, you’ll need to determine whether each of these top holdings are hedgeable. Then, 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 (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 leftover 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 leftover 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 value stocks using the general process described above, facilitated by the automated hedged portfolio construction tool at Portfolio Armor . Narrowing Down Our List of Stocks To get a starting list of value stocks, we used the Large Cap Value screen created by Zack’s Investment Research in Fidelity ‘s stock screener. That screen uses these criteria: Market capitalization of $5 billion and above Projected EPS growth (quarter over quarter) of 17% or more Projected EPS growth (year over year) of 17% or more P/E below 12 PEG below 1 Security price above $5 Average volume over 50,000 shares traded daily On Thursday, that screen generated these 11 stocks: American Airlines Group (NASDAQ: AAL ) Citigroup (NYSE: C ) Delta Air Lines (NYSE: DAL ) Ford Motor Co. (NYSE: F ) Gilead Sciences (NASDAQ: GILD ) HollyFrontier Corp (NYSE: HFC ) Lear Corp (NYSE: LEA ) Southwest Airlines (NYSE: LUV ) Tesoro Corp (NYSE: TSO ) United Continental Holdings (NYSE: UAL ) Valero Energy (NYSE: VLO ) Using the Automated Tool In the first step, we enter the eleven ticker symbols in the “Tickers” field, the dollar amount of our investor’s portfolio (250000) in the field below that, and in the third field, the maximum decline he’s willing to risk in percentage terms (20). In the second step, we are given the option of entering our own potential return estimates for each of these securities. Instead, in this case, we’ll let Portfolio Armor supply its own potential returns. Note that the site’s potential returns are calculated based on price history and option market sentiment, so they generally won’t be very high for value stocks. But, again, you can enter your own potential returns in this step if you want. A couple minutes after clicking the “Create” button, we were presented with the hedged portfolio below. The data here is as of Thursday’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 six of the eleven stocks we entered, DAL, GILD, HFC, LEA, TSO, and VLO. In its fine-tuning step, it added Under Armour (NYSE: UA ) as a cash substitute. Let’s turn our attention now to the portfolio level summary for a moment. 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 19.8%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -2.56%, 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. That also means that if the underlying securities returned 0% over the next 6 months, and the hedges expired worthless, the portfolio would return 2.56% (to be prudent, we suggest exiting positions just before their hedges expire instead). Best-Case Scenario At the portfolio level, the net potential return is 6.32% 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 2.22% represents a conservative estimate, based on the historical relationship between our calculated potential returns and backtested actual returns. By way of comparison, a hedged portfolio created recently using the same decline threshold (20%), but without entering any ticker symbols (i.e., letting Portfolio Armor pick all the securities), had an expected return of 6.1%. You can see that hedged portfolio in a recent article (“Investing While Guarding Against Extensive Vertical Losses”). Each Security Is Hedged Note that each of the above securities is hedged. Under Armour, 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, as calculated by the site. Here is a closer look at the hedge for Gilead Sciences: Gilead Sciences is capped here at 10.62%, because that’s the potential return Portfolio Armor calculated for it over the next several months. As you can see at the bottom of the image above, the cost of the put protection in this collar is $464, or 2.08% of position value. But if you look at the image below, you’ll see the income generated from selling the calls is $640, or 2.87% of position value. So, the net cost of this optimal collar is -$176, or -0.79% of position value, meaning the investor would collect more income from selling the calls than he paid to buy the puts.[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. That’s true of the other hedges in this portfolio as well. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.

Building A Hedged Portfolio Of Governance Metrics International’s Top-Ranked Stocks

Summary A way to potentially boost your returns when building a concentrated portfolio is to start with stocks that are rated highly by quantitative analysis. The Governance Metrics International, or GMI, rating system uses quantitative analysis to assess financial reporting and corporate governance, and determine which stocks are likely to substantially outperform the market. With any quantitative system, there’s a risk the analysis will be wrong, or the market will move against you. Using the hedged portfolio method can limit your downside risk. We show how to create a hedged portfolio starting with top-rated GMI stocks, and provide a sample hedged portfolio designed to limit downside risk to a 20% drawdown. In the Wake of Enron, A Focus On Financial Reporting One of the forensic accounting firms founded in the wake of Enron’s fraud was Audit Integrity, which later changed its name to Governance Metrics International (GMI), and was acquired by MSCI ‘s ESG Integration Unit last year. GMI uses a proprietary quantitative approach to analyze the financial reports and governance practices of public companies. The best-known indicator GMI uses is its Accounting and Governance Risk ( AGR ) ratings, which range from “Very Aggressive” to “Conservative.” According to GMI, companies rated “Very Aggressive” are 10 times more likely to face SEC enforcement actions than those rated “Conservative,” and 4 times more likely to file for bankruptcy. GMI uses its AGR ratings to derive its AGR Equity Risk Factor, which it considers to be a leading indication of share performance. AGR Equity Risk Factor ratings range from 1 (“Substantially Outperform Market”) to 5 (“Substantially Underperform Market”). We’re going to start with the universe of GMI’s 1-rated stocks to build a concentrated, hedged portfolio. Why a Concentrated Portfolio The point of a concentrated portfolio is to invest in a handful of securities with high potential returns, instead of a larger number of securities with lower potential returns. As Warren Buffett noted in a lecture at the University of Florida’s business school in 1998: If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into the seventh one instead of putting more money into your first one is going to be terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. Why a Hedged Portfolio Because we’re not Warren Buffett. We don’t have vast wealth to absorb large losses, and hedging limits our downside risk in the event that we pick the wrong stocks, or the market moves against us. There is, of course, a tradeoff between what we are willing to risk and our 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 25% decline will have a chance at higher returns than one who is only willing to risk, say, a 15% drawdown. For the purposes of this example, we’ll split the difference and create a hedged portfolio designed for an investor with $100,000 who is willing to risk a drawdown of no more than 20%. Constructing A Hedged Portfolio We’ll summarize process the hedged portfolio process here, 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 universe of stocks rated by GMI as likely to “substantially outperform the market”. 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 First, you’ll need to determine whether each of these top holdings are hedgeable. Then, 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 (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 leftover 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 leftover 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 1-rated GMI stocks using the general process described above, facilitated by the automated hedged portfolio construction tool at Portfolio Armor . Narrowing Down Our List of Stocks To get the universe of 1-rated GMI stocks we used Fidelity ‘s screener to screen for optionable stocks rated 1, or “substantially outperform” according to the GMI AGR Equity Risk Rating. Since over 1,000 stocks met those two criteria, we added a third: 52-week price performance in the top 20% by industry. That winnowed the list to 247 names, and we picked the top 5 to input into our automated hedged portfolio construction tool: ABIOMED (NASDAQ: ABMD ) Bassett Furniture Industries (NASDAQ: BSET ) Sketchers USA (NYSE: SKX ) JetBlue Airways (NASDAQ: JBLU ) Universal Insurance Holdings (NYSE: UVE ) Using the Automated Tool In the first step, we enter the five ticker symbols in the “Tickers” field, the dollar amount of our investor’s portfolio (100000) in the field below that, and in the third field, the maximum decline he’s willing to risk in percentage terms (20). In the second step, we are given the option of entering our own potential return estimates for each of these securities. Instead, in this case, we’ll let Portfolio Armor 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 Monday’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 three of the five stocks, ABMD, JBLU, and SKX. Since it aims to include four primary securities in a portfolio of this size, and only three of the ones we entered had positive net potential returns, Portfolio Armor added one of its own top-ranked stocks, Post Holdings (NYSE: POST ). In its fine-tuning step, it added Restoration Hardware (NYSE: RH ) as a cash substitute. Let’s turn our attention now to the portfolio level summary for a moment. 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 18.78%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -0.26%, 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 12.07% 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 4.93% represents a conservative estimate, based on the historical relationship between our calculated potential returns and backtested actual returns. By way of comparison, a hedged portfolio created on Friday using the same and decline threshold (20%), but without entering any ticker symbols (i.e., letting Portfolio Armor pick all the securities), had an expected return of 6.1%. You can see that hedged portfolio in a recent article (“Investing While Guarding Against Extensive Vertical Losses”). Each Security Is Hedged Note that each of the above securities is hedged. Restoration Hardware, 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 JetBlue: JetBlue is capped here at 14.25%, because that’s the potential return Portfolio Armor calculated for it over the next several months. As you can see at the bottom of the image above, the cost of the put protection in this collar is $1,050, or 5.7% of position value. But if you look at the image below, you’ll see the income generated from selling the calls is $735, or 3.99% of position value. So, the net cost of this optimal collar is $315, or 1.71% of position value.[i] Note that, although the cost of hedging this position is positive, the cost of hedging the portfolio as a whole is 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 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. That’s true of the other hedges in this portfolio as well. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.