Summary Portfolio Manager and economist John Hussman warns that “extensive vertical losses” can follow a partial recovery from a correction similar to our recent one. One way to remain invested while guarding against extensive vertical losses is with the hedged portfolio method, which we outline here. We also present an example of a hedged portfolio designed for an investor with $200,000 who is unwilling to risk losses greater than 20%. Hussman Says We’re Due On Twitter (NYSE: TWTR ) earlier this month, the pseudonymous Florida-based trader StockCats shared the following chart, first posted a year earlier: The next day, the creator of the image, portfolio manager, Stanford Ph.D., and former finance professor John Hussman responded: In his next weekly market commentary (“That was not a crash”), Hussman updated his bearish sentiment: The market decline of recent weeks was not a crash. It was merely an air-pocket. It was probably just a start. Actual market crashes involve a much larger and concerted shift toward investor risk-aversion, which doesn’t really happen right off of a market peak. Historically, market crashes don’t even start until the market has first retreated by 10-14%, and then recovers about half of that loss, offering investors hope that things have stabilized (look for example at the 1929 and 1987 instances). The extensive vertical losses that characterize a crash follow only after the market breaks that apparent “support,” leading to a relentless free-fall that inflicts several times the loss that we’ve seen in recent weeks. If you were certain Hussman was right that the recent correction has just been an “air pocket,” and we’re due for worse, then an appropriate course of action might be to get out of the market. But as strong a case as Hussman makes, he’s been making a similar one for years. And even he doesn’t go so far as to predict exactly when he expects we’ll get the crash we’re due to get. So we’re left with the question of how to invest given the uncertainty of whether the long bull market will resume or we’ll soon be faced with Hussman’s ominous “extensive vertical losses.” Dealing With Uncertainty One way to deal with this sort of uncertainty is to invest in a handful of securities you think will do well, and hedge against the possibility that you end up being wrong. That approach is systematized in the hedged portfolio method, which we detailed in a previous post (“Backtesting The Hedged Portfolio Method”). One advantage of the hedged portfolio method is that it can accommodate a broad range of risk tolerances. Below, we’ll recap how you can build a hedged portfolio yourself (or for a client), and present an example of a hedged portfolio created for an investor with $200,000 to invest who can’t tolerate a drawdown of more than 20%. 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 earlier 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 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). Note that when creating a hedged portfolio for an extremely risk-averse investor, such as in this case, the second criteria (“inexpensive to hedge”) will outweigh the first (“high potential returns”) because it may not be possible to hedge the securities with the highest potential returns against such small declines. 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 positive 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 positive 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 4% 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 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. 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 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 Of A 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 . With that tool, you just enter the dollar amount you are looking to invest (in this case, $200,000) and the largest drawdown you are willing to risk (your “threshold” – in this case, 20%), as in the image below, and the tool does the rest. Note that we left the “tickers” field blank above, because, in this case, we’re going to let the site pick all of the securities for us. But you can also start with your own investment picks when using this tool. We shared an example of that in a recent article (“Building a Bulletproof Stock Portfolio”). A couple of minutes after clicking the “create” button above, we were presented with the portfolio below, which was generated with data as of Friday’s close. 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 the hedges expired, the portfolio would decline 18.92%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was slightly negative, -0.01%, meaning the investor would receive a few dollars 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 15.16%. 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 6.10% represents a more conservative estimate, 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 four primary underlying securities – Abiomed (NASDAQ: ABMD ), BofI Holding (NASDAQ: BOFI ), Expedia, Inc. (NASDAQ: EXPE ), and Sketchers, USA (NYSE: SKX ) – is hedged with an optimal collar capped at its potential return, and Amazon (NASDAQ: AMZN ) is hedged as a cash substitute, with its cap set at 1%. 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 net potential returns. Here’s a closer look at the hedge for one of these positions, ABMD: As you can see in the first part of the image above, ABMD is hedged with an optimal collar with its cap set at 21.92%, which was the potential return Portfolio Armor calculated for the stock: the idea is to capture the potential return while offsetting the cost of hedging by selling other investors the right to buy ABMD if it appreciates beyond that over the next six months. The cost of the put leg of this collar was $3,600, or 9.42% of position value, but as you can see in the image below, the income from the short call leg was $2,600, or 6.80% as a percentage of position value. Since the income from the call leg offset some of the cost of the put leg, the net cost of the optimal collar on ABMD was $1,000, or 2.62% of position value.[i] Note that, although the cost of the hedge on this position was positive, the hedging cost of this portfolio as a whole was slightly negative . Why These Particular Securities? As of Friday, all of these securities ranked among the top six names in the site’s universe when ranked by potential return net of hedging costs. 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 ). Hedged Portfolios For Even More Risk-Averse Investors 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. We presented an example of that in a recent article (“An Alternative To Cash For Risk-Averse Investors”). Note: [i] 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.