Summary An investor can “bullet-proof” his portfolio while maximizing his expected return using the hedged portfolio method. When creating a hedged portfolio, you can start from scratch or start with a list of stock picks. We explore the second method here starting with divided growth stocks. We also provide an example hedged portfolio, designed for an investor unwilling to risk a drawdown of more than 15%. This portfolio has a negative hedging cost. Another Cause For Uncertainty In a recent article (“Investing Alongside Buffett, Klarman and Other Top Investors While Limiting Your Risk”), we mentioned that the reactions to the economic data released Friday exemplified the uncertainty about the current economic environment, centered on the question of whether the Federal Reserve would raise rates soon. However, one of the top trending articles on Seeking Alpha over the weekend (“Something is Still Ridiculously Wrong”) argued that focussing on the when the Fed will raise rates is missing the point. In that article, written a couple of weeks before Friday’s jobs report data was released, Seeking Alpha contribor and mutual fund manager Michael Gayed, CFA, wrote that the bigger concern is that the Fed’s efforts at reflation haven’t helped the real economy, and that could have ominous implications, That is dangerous on many levels, and if the stock market begins to care about the fact that all of these tools central banks are using aren’t actually filtering to the economy, then the future is likely to be extraordinarily more volatile than the past. Dealing With Uncertainty Gayed’s article generated an extraordinary number of comments – 851, as of Monday night – with opinions divided as to his prognosis. One of the top commenters predicted that when his favored candidate is elected President, the stock market will hit new highs. Another top commenter praised Gayed for sounding his warning. Once again, we’re left with the uncertainty that no one knows what direction the market will take from here, and the question of how to invest confidently given that uncertainty. One way to deal with this sort of uncertainty about market direction is to invest in a handful of securities you think will do well, and to “bullet proof” them by hedging 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”). An advantage of the hedged portfolio method is that, as our research suggests, it can generate competitive returns over time at a broad range of risk tolerances. Maybe You Can Do Better It’s possible you can get even better returns with the hedged portfolio method by selecting your own securities. And if you’re going to do that, Seeking Alpha can be a good starting point for ideas. For example, Seeking Alpha contributor Chuck Carnevale recently offered an interesting list of dividend growth stocks (“12 Attractive Fast-Growing Dividend Growth Stocks”). For his article, prompted by a question by a younger reader interested more in the potential for dividend growth than current yield, Carnevale screened for companies with above average earnings and dividend growth that he felt were trading currently at attractive valuations. Carnevale’s article included this chart listing the twelve stocks he came up with, along with some of the key metrics he used to screen for them: (click to enlarge) Carnevale’s article is worth a read for some additional color on these stocks and his screening methods and tools. But we’ll start with the assumption that most of these are solid stocks, and we’ll use them as a starting point to construct a hedged portfolio for an investor who is unwilling to risk a drawdown of more than 15%, 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 15% decline will have a chance at higher returns than one who is only willing to risk, say, a 5% drawdown. Constructing A Hedged Portfolio In the article about backtesting mentioned above, we discussed a process investors could use to construct a hedged portfolio designed to maximize potential 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 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 Chuck Carnevale’s list of dividend growth stocks. 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-15% 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 Chuck Carnevale’s twelve fast-growing dividend growth stocks using the general process described above, facilitated by the automated hedged portfolio construction tool at Portfolio Armor . In the first step, we enter the ticker symbols in the “Tickers” field, the dollar amount of our investor’s portfolio (500000), and in the third field, the maximum decline he’s willing to risk in percentage terms (15). In the second step, we are given the option of entering our own 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 Friday’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 just two stocks, Apple (NASDAQ: AAPL ), and Gilead Sciences (NASDAQ: GILD ). Since it aims for including six primary securities in a portfolio of this size, and only two of the ones we entered had positive net potential returns, Portfolio Armor included four of the stocks with the highest net potential returns at the time in its universe in the portfolio. Those were Advance Auto Parts (NYSE: AAP ), Alliance Data Systems (NYSE: ADS ), Amazon (NASDAQ: AMZN ), and Regeneron Pharmaceuticals (NASDAQ: REGN ). In its fine-tuning step, Portfolio Armor added Celgene (NASDAQ: CELG ) 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 14.43%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -0.96%, 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 16.22% 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 5.62% represents a conservative estimate, based on the historical relationship between our calculated potential returns and backtested actual returns. By way of comparison, if you created a hedged portfolio on Friday using the same dollar amount ($500,000) and decline threshold (15%), but without entering any ticker symbols (i.e., you let Portfolio Armor pick all the securities), the expected return for that hedged portfolio would have been 7.42%. Each Security Is Hedged Note that each of the above securities is hedged. Celgene, the cash substitute, is hedged with an optimal collar with its cap set at 1%; Advance Auto Parts is hedged with optimal puts; 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 Gilead Sciences: Gilead is capped here at 5.67%, because that’s the potential return Portfolio Armor calculated for it over the next several months. As you can at the bottom of the image above, the cost of the put protection in this collar is $2,220, or 3.63% of position value. But if you look at the image below, you’ll see the income generated from selling the calls is $3,300, or 5.39% of position value. So, the net cost of this optimal collar is negative.[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 recent instablog post on hedging Tesla (NASDAQ: TSLA ). Hedged Portfolios For Smaller Investors The hedged portfolio shown above was designed for someone with $500,000 to invest, but the same process, with a couple of minor adjustments, can be used for those with smaller amounts to invest. We walked through creating a hedged portfolio for someone with $30,000 to invest in an article last month (“Keeping a Small Nest Egg from Cracking”). [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 (i.e., an investor would have likely collected more than $1080 when opening this hedge). 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.