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Summary A small investor can protect himself against a severe correction while maximizing his expected return by using a hedged portfolio, such as the one shown below. This portfolio has a negative hedging cost, meaning the investor would effectively be getting paid to hedge. This portfolio is designed for an investor who is willing to risk a maximum decline of up to 20%. Investors with lower risk tolerances can use a similar process, though their expected returns would generally be lower. Seeking Direction as Investor Concerns Mount As Seeking Alpha contributor Eric Parnell, CFA noted , (“Stocks: Perspectives On The Selloff”), the four-day decline in the S&P 500 index last week was the worst since October of 2011. The stock market slide coincided with fresh indicators of global economic weakness, including oil futures dropping below $40 per barrel on Friday. On Sunday night New York time, and Monday morning in Shanghai, the Shanghai Composit Index opened down sharply. CNBC aired a rare live Sunday evening broadcast (” Markets in Turmoil “) in response to the negative market news. During the broadcast, analysts and anchors debated whether the pullback would continue, and how investors should respond. I didn’t watch the entire broadcast, but the part I saw conformed to previous, similar specials: a guest expert says the pullback could be a buying opportunity, reiterates the importance of having a long term horizon, etc. In reality, no one knows what the future holds, but small investors can strictly limit their risk while remaining invested in the stock market. Another Way To Invest Small investors don’t have to live with worry that they might suffer an intolerable loss in the stock market. With a hedged portfolio, they can decide the maximum drawdown they are willing to risk, and invest confident that their downside risk is strictly limited in accordance with that. In the example below, we’ll show a sample hedged portfolio designed to protect a small investor against a greater-than-20% loss over the next six months while maximizing his expected return. We’ll also detail how an investor can build a hedged portfolio himself. The first decision an investor needs to make, though, is how much he is willing to risk. Risk Tolerance, Hedging Cost, 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”) — the lower his hedging cost will be and the higher his expected return will be. An investor who is willing to risk a 20% drawdown is in good company. Several years ago, in one of his market commentaries , portfolio manager John Hussman had this to say about 20% drawdowns: “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).” Essentially, 20% is a large enough threshold that it can reduce the cost of hedging, but not so large that it precludes a recovery. Constructing A Hedged Portfolio In a previous article (“Backtesting The Hedged Portfolio Method”), we discussed a process investors could use to construct a hedged portfolio designed to maximize expected return while limiting risk. We’ll recap that 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 Portfolio Armor ‘s 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 securities with high potential returns. For this, you can use Seeking Alpha Pro , among other sources. Seeking Alpha articles often include price targets for long ideas, and you can convert these to percentage returns from current prices. But you’ll need to use the same time frame for each of your expected return calculations to facilitate comparisons of expected returns, hedging costs, and net expected returns. Our method starts with calculations of six-month potential returns. · Finding securities that are relatively inexpensive to hedge. For this step, you’ll need to find hedges for the securities with high potential returns, and then calculate the hedging cost as a percentage of position value for each security. 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. · Buying securities that score well on the first two criteria. In order to determine which securities these are, 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 sort the securities by their potential returns net of hedging costs, or net potential returns. The securities that come to the top of that sort are the ones you’ll want to consider for your portfolio. · 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. Stocks such as Priceline.com (NASDAQ: PCLN ), trading at more than $1200 per share, wouldn’t work in a $30,000 hedged portfolio, because the investor wouldn’t be able to purchase one round lot. 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 An Expected Return. 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. Example Hedged Portfolio Here is an example of a hedged portfolio created using the general process described above by the automated portfolio construction tool at Portfolio Armor. This portfolio was generated as of Friday’s close (results could vary at different times, depending on market conditions), and used as its inputs the parameters we mentioned for our hypothetical investor above: a $30,000 to invest, and a goal of maximizing potential return while limiting downside risk, in the worst-case scenario, to a drawdown of no more than 20%. Worst Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst case scenario for this hedged portfolio. If every security in it went to zero before the hedges expired, the portfolio would decline 18.67%. Negative Hedging Cost Although minimizing hedging cost was only the secondary goal here after maximizing potential return, note that, in this case, the total hedging cost for the portfolio was negative, -1.23%, 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 put legs. Best Case Scenario At the portfolio level, the net potential return is 17.79%. 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 6.86% represents a more likely scenario, based on the historical relationship between our calculated potential returns and actual returns. Each Security Is Hedged Note that in the portfolio above, each of the three underlying securities – Netflix (NASDAQ: NFLX ), Facebook (NASDAQ: FB ), and DexCom (NASDAQ: DXCM ) is hedged. Hedging each security according to the investor’s risk tolerance obviates the need for broad diversification, and lets him concentrate his assets in a handful of securities with high potential returns net of their hedging costs. Here’s a closer look at the hedge for one of these positions, Netflix: As you can see in first part of the image above, NFLX is hedged with an optimal collar with its cap set at 21.92%. Using an analysis of historical returns as well as option market sentiment, the tool calculated a potential return of 21.92% for NFLX over the next six months. That’s why 21.92% is used as the cap here: the idea is to capture the potential return while offsetting the cost of hedging by selling other investors the right to buy NFLX if it appreciates beyond that over the next six months.[i] The cost of the put leg of this collar was $820, or 7.89% of position value, but, as you can see in the image below, the income from the short call leg was $770, or 7.41% as percentage of position value. Since the income from the call leg offset most of the cost of the put leg, the net cost of the optimal collar on NFLX was $50, or 0.48% of position value.[ii] Note that, although the cost of the hedge on this position was positive, the hedging cost of this portfolio as a whole was negative . Why These Particular Securities? Netflix and DexCom shares were included as primary securities in this portfolio because, as of Friday’s close, they were both among the top securities in Portfolio Armor’s universe when ranked by net potential return, and they had lower share prices than other securities similarly highly ranked. Recall from our discussion above about fine-tuning portfolio construction, that it can be difficult to fit round lots of securities with higher share prices in smaller portfolios. Facebook was included as a cash substitute because it had one of the highest net potential returns when hedged as a cash substitute. 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 post on hedging Netflix last year. Hedged Portfolios For Investors With Lower Risk Tolerance The hedged portfolio shown above was designed for a small investor who could tolerate a decline of as much as 20% over the next six months, but the same process can be used for investors who are more risk averse. Using data as of Friday’s close, we were also able to construct a hedged portfolio for an investor only willing to tolerate a loss of a tenth as much, 2% over the next six months. —————————————————————————– [i] This hedge actually expires in a little more than 7 months, but the expected returns are based on the assumption that an investor will hold his positions for six months, until they are called away or until shortly before their hedges expire, whichever comes first. [ii] To be conservative, the net cost of the collar was calculated using the bid price of the calls and the ask price of the puts. In practice, an investor can often sell the calls for a higher price (some price between the bid and ask) and he can often buy the puts for less than the ask price (again, at some price between the bid and ask). So, in practice, the cost of this collar would likely have been lower. 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.