Tag Archives: nasdaq

Protect Your Portfolio Against Risks

Uncertainty in the market is increasing, which means that investors want to insure themselves against risks. Hedging is one way to protect a portfolio against losses. Hedging with options is a popular method that has a lot of shortcomings. A market-neutral portfolio is a hedging method in which the distinguishing feature is the lack of correlation with the market. A market-neutral portfolio enables investors to make a profit when the market takes a nosedive, but this method has to be used carefully. It’s not uncommon to hear that there is a bubble forming in the market. The more a market grows, the more participants start to voice such concerns and the more convincing their arguments sound. However, aside from bubbles such as the dotcom crash in 2000 or the crisis of 2008, there are other situations that impact investors negatively. The slowdown of the Chinese economy, the crisis in Greece and the expectation of increases in interest rates are all factors of uncertainty that put pressure on the market this year. The increase in uncertainty on the market means that a lot of investors want to insure themselves against risks and retain profits made during years of rapid growth. The simplest way to protect yourself against risks is to have a cash position. This position is the least affected by risks and allows investors to take advantage of the opportunities that may present themselves if the market crashes. For example, the recent Flash Crash allowed market participants to purchase stocks of great companies at low prices. Nonetheless, cash positions have one major disadvantage – during periods of market growth, they significantly limit potential returns. Hedging is another way to insure a portfolio against risks. A hedge is a position in an instrument that serves to decrease potential losses on a position in another instrument. Hedging with options is one of the most popular ways to hedge. Options can be used to create all sorts of different hedging strategies. Let’s look at a few basic examples. Protective puts . One of the simplest hedging strategies – the purchase of put options with a strike price at the level of tolerable losses. Let’s look at a scenario in which an investor purchases a stock for $100 and in which the amount he/she is willing to lose is 15%. After purchasing a put option with a strike price of $85, the investor will ensure that the most he or she will lose is 15%. The investor is paying a premium when he/she buys put options – essentially paying for insurance against risk. Collar . The premium an investor must pay to purchase a put option can be quite large. The system of hedging a portfolio with a collar allows to decrease these risk insurance costs. In this strategy, the investor simultaneously purchases a protective put and sells an out-of-the-money call option. By selling the call option, the investor receives a premium that can cover part of the expenses for purchasing the put option. In some cases, the premium received from the sale of a call option can be higher than the premium spent for the purchase of the put option. Thus, the investor essentially gets paid for hedging their position. However, in selling the call option, the investor limits potential income from the long position. This is why the collar strategy only makes sense if the investor expects the price of stocks they purchase to not exceed the strike price of call options they sell. In spite of the popularity of these strategies, hedging with options has a number of serious disadvantages. First, the options market is too difficult to navigate for many individual investors, which is why they prefer to not trade instruments they don’t understand. Second, liquid options don’t exist for all securities, or premiums on the options can be very high. Options strategies described above help to limit losses of the portfolio. But smarter way of hedging is reducing the exposures of the portfolio to different kinds of risk. A better hedge is one that would not only cut down on potential losses, but would eliminate a portfolio’s correlation with the market and other risk factors such as sector specifics (this is relevant, for example, for the Energy sector, which dropped significantly when oil prices fell). A market-neutral portfolio is one such hedging strategy. The idea behind a market-neutral portfolio is that the investor takes a long position on a number of instruments in the portfolio, and shorts the rest. In this way, if the portfolio is put together correctly, there is an opportunity to make profits regardless of how the market behaves. The most popular example of a market-neutral portfolio strategy is pair trading, which is when an investor takes long position in one stock and shorts another (with different weights) in case of widening of spread between their prices. The expectation is that the spread will eventually be become narrower. Pair trading is quite simple in theory, but difficult to carry out in practice. In order to be implemented successfully, investors have to find the right pairs to pair trade. It is best to have more than one pair so that a potential loss on one would be covered by profits from the others. Moreover, it is necessary to determine the weights on long and short positions in each pair, since the securities can have different beta coefficients against the market. Pair trading opportunities do not come up systemically, which is why an investor has to constantly monitor pairs – not a good strategy for those who prefer to only trade occasionally. There has to be a stop-loss for each pair, since the difference between each pair may never diminish, but rather continue to increase in the future. Finally, broker commissions for short positions may make opening a short position on a security in a potential pair impossible. A much simpler implementation of the market-neutral portfolio strategy is as follows. The investor longs stocks and shorts index futures (with adjustment for the beta of the long part of the portfolio against the index). This portfolio would have a correlation with market that is close to zero because of the short part. Profits will depend on how much better than the market the long stocks perform on a risk-adjusted basis. In other words, this portfolio will allow the investor to extract the alpha of securities in the long position. With the development of ETFs, constructing such portfolios has become a lot easier. Instead of shorting futures (the price of E-mini futures does not allow investors to use them to hedge small portfolios), inverse ETFs can be used – ProShares Short S&P 500 ETF (NYSEARCA: SH ), for example. Moreover, sector risks can be hedged by using sector ETFs as hedges. An investor could profit on recent biotech plunge by hedging portfolio of best biotech stocks with iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ). An important advantage of this portfolio is the fact that it does not require a large number of trades. All the investor has to do is occasionally correct the size of the position in the hedge to make sure that it doesn’t differ too much from the long position (with respect to the beta). Here is an example of a backtesting of implementation market-neutral portfolio strategy. We conduct backtesting, starting on 01/01/2008. The backtesting period’s start date was set to 01/01/2008 to include periods of both market decline and market growth. We apply simple screening to choose stocks for the portfolio. On the first step of the screening we limit the universe of 500 US companies with the largest market cap to 100 with the lowest 1-year volatility. On the second step we pick top 20 stocks by dividend yield from 100 stocks that have been chosen on previous step. This portfolio presumably should generate excess return against the market on a risk-adjusted basis. In order to make portfolio “market neutral” we should add hedge to the portfolio. As a hedge we would use short position in SPY. The proportion of assets allocated in hedge should be equal to beta of the portfolio against hedge. Then beta of the hedged portfolio would be equal to zero. In other words, hedged portfolio would be market-neutral portfolio. We would rebalance this portfolio quarterly. Rebalancing is necessary because: It insures that stocks in the portfolio match our screening criteria; It helps to adjust allocation of assets in long and short parts of the portfolio, so that the beta of hedged portfolio would be zero. Beta of the portfolio is recalculated on each rebalancing date. (click to enlarge) At the selected interval, the portfolio has an Annualized Return that is comparable to S&P 500 (NYSEARCA: SPY ). The Maximum Drawdown is much lower, while the Sharpe Ratio is higher. Of course, hedging a portfolio like this is not free. In this case, the price is that a neutral portfolio will show moderate returns during market boom periods. Investing always involves risk: the market is volatile, and this volatility is influenced by both fundamental factors and by noise. Forecasting a market drop is almost impossible, which is why it makes sense to hedge portfolios during periods of uncertainty in order to avoid significant losses. A market-neutral portfolio is a type of hedging that allows investors to limit losses and make profits in any market conditions, since the profitability of such portfolios does not depend on market shifts. But during market booms, such portfolios will be less profitable than regular ones. This is why investors with moderate risk tolerance can employ this hedging strategy periodically, when uncertainty is high.

Why I Sold Berkshire Hathaway And Added Quality To My Portfolio

Summary Berkshire Hathaway may be a model for a quality company and merits a place in one’s portfolio on that basis. Berkshire Hathaway’s recent performance has been disappointing. Can an ETF focused on the quality factor replace it and improve returns as well as portfolio quality? I continue to review my holdings with an eye to what I want to keep and what’s not earning its keep. After a hard look, I decided Berkshire Hathaway (NYSE: BRK.B ) just wasn’t getting it done. Take a look at some stats for BRK.B and the ETFs tracking the S&P 500 and the NASDAQ 100. Annualized Volatility Beta Daily Value at Risk Max Drawdown Total Return (1 year) BRK.B 14.2% 0.91 2.1% -6.3% 4.4% SPDR S&P 500 Trust ETF ( SPY) 12.7% 1.00 1.9% -4.9% 9.5% PowerShares QQQ Trust ETF ( QQQ) 13.7% 0.99 2.0% -5.7% 11.8% Looking at these numbers, I asked myself “Why?” Why do I need something that I think of as high-quality but ultraconservative yet has greater volatility than the NASDAQ 100. And with that volatility comes barely a third QQQ’s return. It has greater volatility than the S&P 500 as well, and half of SPY’s return. Sure, the stock has had great years in the past, but when I ask what it’s done for me lately, I’m not getting an answer that tells me to hold onto it, especially since it’s a large holding for me. The question was, what do I replace it with? In looking for the answer, I asked myself why I was holding BRK.B. What came immediately to mind? Quality. When I bought the stock it was because I viewed it as the model for quality. So, while I was deciding to part ways with BRK, I had to decide how to fill the gap it would leave. I might have begun by considering other stocks, of course. But, another factor that entered into my thinking is that I have been moving away from individual stock holdings in favor of funds. That decision is the subject of another discussion altogether, but especially for places where a stock is occupying a structural role in my portfolio, I think it can make more sense to fill that slot with an ETF that does the same job. So, what I wanted was a fund that emphasized high-quality. What Asness et al., following the Fama-French factor terminology, called Quality Minus Junk in their 2013 paper on the subject. In that paper they define quality stocks as being “safe, profitable, growing, and well managed” and showed how the quality factor has outperformed. After BRK.B had a nice pop on Thursday and Friday, I decided it was time. I could have gone with one of AQR’s mutual funds, which are built on Asness’s rigorous research. But, even if the door was open to me, I’m not in a position to fork out the cost of entry. These funds have a nominal minimum purchase of $1-5 Million depending on share type. I have a large holding in BRK.B but not remotely that large. In addition there are fees that approach 2%, and the funds are generally available only through advisors. I’m sure you can get in for less than that nominal seven-figure requirement if your timing and brokerage are right. In fact I do hold an AQR mutual fund purchased this way despite its nominal $1M minimum. But most of them are closed to new or even current investors. A smart move by the funds’ management, keeping the funds something halfway between an open-end and closed-end mutual fund. I won’t argue the desirability of AQR mutual funds, but as I go through them, I don’t see enough to justify those barriers to me. What I went for was the iShares MSCI USA Quality Factor ETF (NYSEARCA: QUAL ), which does what it says on the label: Emphasizes the quality factor. QUAL: Top Ten Holdings and Sector Distribution When I start to look at an ETF almost the first thing I do is look at the portfolio. (click to enlarge) I found that the top six positions in QUAL were also in my own portfolio: Microsoft (NASDAQ: MSFT ), Johnson & Johnson (NYSE: JNJ ), Apple (NASDAQ: AAPL ), Gilead (NASDAQ: GILD ), Berkshire Hathaway and Costco (NASDAQ: COST ). Four more of my stocks were in the top 20: Celgene (NASDAQ: CELG ), AT&T (NYSE: T ), Chevron (NYSE: CVX ) and Qualcom (NASDAQ: QCOM ). I hold a total of 14 individual stocks, and I look primarily for quality in my choices. So, I was struck by the convergence of my opinion and that of QUAL’s passive algorithm. I’m not sure I’ve ever looked at an ETF portfolio and found 70% of my portfolio’s stocks in the ETF’s top 20. And I’m certain I’ve never hit all of the first 6. I felt the algorithm validated decisions I’ve made over a period of several years, and this fund was a fit for my own approach to investing. Sector weighting also aligned with my own portfolio strategies. (click to enlarge) I have a modest allocation to a dual-momentum sector-switching strategy. For the past year and a half or so it’s been in information tech, healthcare, consumer discretionary most of the time it hasn’t been in the out-of-market position. The QUAL index has loaded the portfolio with 70% allocation to those sectors. Again, I felt I was moving along the same path. So, with the validation that my investment strategies and QUAL’s index algorithm were generating similar choices, it seemed clear that I had to look more closely. QUAL’s Strategy and Implementation Quality can be a nebulous concept. The most important question was: How does the fund define quality? According to the fund’s factsheet they use “three fundamental variables: high return on equity, stable year-over-year earnings growth and low financial leverage.” Not unreasonable indicators of Asness’s “safe, profitable, growing, and well managed” definition of quality. The MSCI index description expands this with the quantitative details: A quality score… is calculated by combining Z scores of three winsorized fundamental variables-Return on Equity, Debt to Equity and Earnings Variability. MSCI then averages the Z scores of each of the three fundamental variables to calculate a composite quality Z score… then ranks all constituents of the parent index based on their quality scores. Weighting is determined by the product of market cap weight in the index and quality score. Weights are capped at 5%. As an aside to stock-pickers, think about how high MSFT and JNJ must score on the quality scale to overcome AAPL’s market cap advantage in rising above it in the weighting here. It’s an approach that should lead to emphases on both fundamental value and momentum. I liked what I saw, and feel most would agree that these indicators do indeed reflect a concept of a quality company. They are clearly necessary components of quality, although perhaps not sufficient. I’m sure all of us could add metrics we’d like to see included. But I was satisfied with it at this level. QUAL’s History The fund has 27 months of history (July 16, 2013) and net assets of $1.2B. The total portfolio is set at 125 holdings. SEC 30-day yield as of September 30 is 1.94%. Its beta is 0.92. And its fee is only 0.15%. Returns since the fund’s inception are about a third better than SPY and twice what BRK.B has turned in. (click to enlarge) For longer term evaluation we have to go to the index. It’s always problematic to base decisions on a fund using the historical performance of its index, but it’s what we have. Here we have MSCI’s 15 year chart of the index vs. its USA index of domestic stocks. (click to enlarge) Morningstar’s Samuel Lee looked at the fund and its index about a month after it was introduced ( here ). He called it a “Buffett in a Box,” and ran up this analysis where he divides the MSCI Quality Index by the MSCI USA Index. On this chart positive numbers represent outperformance of the quality index relative to the domestic market index. For the 30 years prior to QUAL’s inception the index outperformed by 60%. What you really want to see in this chart, however, is the changes in slope because the positive slopes represent periods of QUAL’s outperfomance. During bull markets, quality lags, but during downturns it shows its breeding. (click to enlarge) Lee compared QUAL to the Vanguard Dividend Appreciation ETF (NYSEARCA: VIG ) noting the he’ll be watching it in comparison to VIG with an eye toward moving his VIG position to QUAL if the fund evolved as he anticipated it should. Here’s what he would have seen when he followed through: (click to enlarge) Trading for Quality So, near the close on Friday I sold my entire position in BRK.B and put the proceeds into QUAL. I started my project to replace individual stocks with funds by focusing on BRK.B for two reasons. First, it has been turning in disappointing returns recently, and second I have a large allocation to the stock, larger than I feel appropriate. There are two other stocks I’m holding at much lower allocations that I have been looking to trade out of as well: JNJ and T. I like having both of them for the same reasons I like BRK.B: stability and quality. But, like BRK.B there underperformance comes with opportunity costs. How do those opportunity costs stack up against what QUAL has been returning? (click to enlarge) What this is telling me is that I can jack up my returns with little, if any, sacrifice in portfolio quality by moving these allocations to QUAL as well. The biggest problem I have with QUAL is one of the things that attracted me to it in the first place. That is the extent to which it duplicates what I’m already holding. I’m not prepared to trade out of GILD, COST or CELG at this time. I think each of those has excellent prospects to outperform the market and their sectors. I also hold a large (my largest, in fact) position in AAPL that I’d like to cut back. I’ll probably do so after earnings this week if, as I expect, we get another positive report. But my other duplications I’m more ambivalent about. I like MSFT and it is certainly not underperforming (75% total return vs. QUAL’s 33.5% on the scale of the above charts) but if I had a quality substitute, I would not miss it. The other I replicate is CVX where I’m underwater but am willing to wait for the oil cycle to turn before I do anything there. Of course, most funds I own replicate some part of my portfolio, especially with AAPL and GILD among the top holdings of nearly every fund I find interesting. Bottom line on this exercise for me: I like QUAL, perhaps as much as any ETF I’ve looked at recently. For my purposes, it can serve the same role in my portfolio as individual stocks of quality that have been, and likely will continue to be, underperforming the market.