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Buffetteer17 and John Hussman, Ph.D.
Posted by: David Pinsen (IP Logged)
Date: October 28, 2008 09:04AM

Both had hedged their portfolios and thus avoided the huge losses most of the gurus on here (and most of the rest of us) have suffered so far this year.

My signature: I blog at [steamcatapult.com]


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Re: Buffetteer17 and John Hussman, Ph.D.
Posted by: Alex Garcia (IP Logged)
Date: October 28, 2008 09:42AM

Awesome job B17 and J.H *tips hat*

Magic Formula Investing


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Re: Buffetteer17 and John Hussman, Ph.D.
Posted by: buffetteer17 (IP Logged)
Date: October 28, 2008 05:47PM

History of the Hedge. Every quarter, I do a writeup on my portfolio, so I can recall what I was thinking and review previous mistakes. Here are excerpts from the quarterly reports, starting with the Q2-2007 one. Apologies for the repetition, but I wanted each quarterly writeup to stand alone.

Q2-07: (hedge 1.0%) I started a small hedge position, comprising S&P 500 index puts with various dates going out about a year, and various strike prices around 1200-1300. The purpose of the hedge is to make it safer for me to use debt and margin to buy stocks. The portfolio yield has stayed in a band from 20% to 30%/year, after tax, for a couple of years now. I can borrow money at an after-tax rate of under 6%. Why not borrow at 6%, earn at 25%, and pocket the difference? The answer of course is risk; a serious bear market could easily reverse that 25% to minus 25%. There is also the risk of a margin call, disrupting the portfolio by forcing me to sell great companies at depressed prices. But if there is a serious correction or bear market, those S&P index puts will become extremely valuable, giving me something besides good stocks to sell to meet margin requirements. It may sound like I'm going way out on a limb, but I'm not. I'm limiting my margin debt to about 20% of capital. The hedge, incidently, is actually currently making a profit, since I bought the puts at market peaks. However, my fervent hope is that hedge expires worthless. It is strictly insurance against severe market corrections.

Q3-07 (hedge 2.8%) I slightly increased my hedge position in S&P 500 index puts with strike prices around 1250, and I will keep it going as long as I'm using margin debt. Currently margin debt is around 30%. Oddly, I've actually made a small profit on the hedge, since the S&P 500 has gone down a little since I started it. With the present combinination of high returns (32%) and high margin debt (30%), I feel quite comfortable paying the 2%/year or so that the hedge is likely to cost me for insurance. At some point, I will pay off the debt, and rethink whether the hedge is a good idea.

Q4-07 (hedge 6.8%) The Portfolio is fairly highly leveraged right now, at about 35% margin loan. This leverage was mostly taken after the big Nov. drop in the market, to pick up bargains. Hopefully, the 6.8% of S&P 500 index puts will give sufficient protection against margin calls if the market tanks in 2008.

Q1-08 (hedge 13.1%) I entered the quarter more than fully invested, about 130%, and ended it about 150% invested. I wasn't very active...Actually my S&P 500 index put options were up more than anything else on a percentage basis this quarter, 48%, but I consider them insurance rather than a for-profit investment.

A few words about those S&P 500 index put options. I bought them at market highs last year. I was concerned that The Portfolio was doing too well. In Oct. 2007, it was yielding a CAGR of 39%. And that was return on assets. The return on equity was higher, about 50%, since I was about 20% on margin. While I might dream that I was the second coming of young Warren Buffett, when I woke up, I knew it wasn't so. It was largely luck, leverage, and a 3 year bull market, and---perhaps---a little bit of skill. I did not predict the bottom would fall out of the market, but I did consider what would happen to a leveraged portfolio if it did. So I decided to sacrifice a few percentage points of returns in exchange for market crash insurance. I bought S&P 500 index puts with a face value (sum of strike prices) of about 2x the size of The Portfolio. Average strike price was around 1250 and average time to expiration around 18 months. The two key objectives were to put in a floor below which The Portfolio is very unlikely to fall, and to provide funds to meet margin calls if they come. Most of my put buying was around S&P 500 level of 1500-1550, so the options would not protect much against moderate drops, say 20%. But they would become extremely valuable on a drop of 40-50%. The cost of the puts was about 6% of The Portfolio. Given that the lifetime of the options is about 18 months, and that the cost is deductable (assuming they expire worthless), this would hurt my total return by about 3%/year. As it happened, the damage is already reduced to about 1%/year, since I sold a few the puts on 1/22/08 and 3/7/08 for incredible percentage gains. Without the puts, my loss this quarter would have been 22% instead of 16%. The puts don't really fully kick in until S&P 500 level of about 1250.

Q2-08 (hedge 13.2%) The hedge comprises a number of S&P 500 index put options, with a face value (sum of strike prices) of about 2x the stock portfolio, with strike prices varying from 1350 to 800, and expirations of 12-18 months. The hedge is doing its job fairly well. That job is to insure against margin calls and put a floor under my net worth. The floor turned out to be a little lower than I planned, because my stock portfolio declined faster than the S&P 500 index. During the market dip in late June, I sold down a little. This reduced my basis cost for the options to 2.5% of my portfolio and the remaining options are up 186%. I'm in no danger of being forced to sell undervalued stocks due to a margin call. If the S&P 500 drops further and my stocks drop proportionally, I'll actually gain quite a bit, since the options are now sufficiently close to the strike prices that they have quite high deltas. I estimate that the existence of the hedge has added 3.7% to my returns since inception.

Q3-08 (hedge 10.8%) The hedge comprises a number of S&P 500 index put options, with a face value (sum of strike prices) of about 1.5x the stock portfolio, with strike prices varying from 1250 to 800, and expirations of 12-18 months. I bought the hedge a little over a year ago, at a cost of about 4% of the portfolio value. I had no idea that the stock market would crash and the economy would enter recession. But I was concerned about the collapsing housing market and early hints of a credit freeze. I figured I would take out some cheap insurance, just in case. The hedge is doing its job fairly well. That job is to insure against margin calls and put a floor under my net worth. The floor turned out to be a little lower than I planned, because my stock portfolio declined faster than the S&P 500 index. This quarter I sold about 1/4 of the options. By now, the profit from the hedge is so much that even if the remaining options expire out of the money, the hedge has more than paid for itself. This has been by far my best investment of the year, with returns north of 300%/year. Too bad I didn't put more money into it.


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Re: Buffetteer17 and John Hussman, Ph.D.
Posted by: fk (IP Logged)
Date: October 28, 2008 07:45PM

Great work Buffetteer!

You've outperformed most of the gurus by 40% to 80% with this hedging strategy. I've been paying value investing "gurus" 1% to 2% a year fund management fees to lose 45% to 60% of my money for me. That's like injury to insult, or injury to injury. I sure would have been better off spending 2% instead using your hedging strategy, hand picking all the stock picks myself and not holding any mutual funds at all.

I've not bought or sold any options yet, that's a new frontier for me, but it seems like it's worthwhile to educate myself on how to hedge as I cost average down buying stocks into the market bottom.

So for example's sake, if I decide to initiate a position on LUK that fills up 10% of my portfolio, what would be the best strategy?
1. buy call options, exercise them right before they expire, unless they open market price for LUK is cheaper at the exercise expiration date.
2. buy LUK stock at today's price, and purchase some options to insure against LUK falling significantly below today's price?

Are there other ways to go about filling 10% of my portfolio with LUK using options?




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Re: Buffetteer17 and John Hussman, Ph.D.
Posted by: David Pinsen (IP Logged)
Date: October 28, 2008 10:19PM

Buffetteer,

Thanks for that recap of your notes. If you don't mind, I plan to mention it and link to it on my blog.

My signature: I blog at [steamcatapult.com]


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Re: Buffetteer17 and John Hussman, Ph.D.
Posted by: buffetteer17 (IP Logged)
Date: October 29, 2008 05:27AM

Before using options, take the time to study a good book or article about how they work. Especially learn the tax implications if you are in a high tax bracket.

Many of the companies I invested in were small caps or thinly traded, which didn't have a good selection of options available, or if they were available, the premium was too high. Major index options are very liquid and very reliable. That's why I elected to use index options rather than put options on individual stocks as insurance.

Tax considerations make using puts on individual stocks that you own a little messy. As I understand it (and I am not a tax advisor, you are on your own), when you buy a put option on a stock you own, you create an implicit straddle. This resets your basis date on the stock for tax purposes under certain conditions. It is a mess. Index options have none of these issues.

Generally, a defense of a new stock position comprises buying the stock and a put option somewhat (10-20%) out of the money. Then if the stock price falls below your option strike price, you are protected from further losses.

It is almost never a good idea to actually exercise an option. The reason is that right up to the expiration data, options have some premium or time value. It is better to sell the option and collect that premium. I have some incentive options on my own company stock, which I was thinking of exercising last year. My tax advisor said, no, no, if you like the stock, just buy it in the open market, and exercise/sell the options.

For your specific question, say you bought LUK and a put option, the price has dropped, and you want out. Just sell the stock and the option at the same time.

Call options are a whole different game. I buy those when I want to participate in the upside but not the downside movement of a stock. An example is banks. I am not capable of analysing banks, and in tough times bank stocks can really go bad. However, I think as a class, the major banks are bound to do well in the next couple of years, given the governmental support. So I bought out-of-the-money call options on several of them in late 2007. The most I can lose is the price of the option, but my upside is unlimited.


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Re: Buffetteer17 and John Hussman, Ph.D.
Posted by: Sivaram (IP Logged)
Date: October 29, 2008 11:12AM

Being a self-proclaimed contrarian, let me disagree with everyone here :) Don't take this the wrong way but I'm still not sold on the options idea. Before I say anything, let me congratulate Buffetter17 on his success so this isn't a critism of him; rather, it is comment about the whole strategy.


I'm a fan of Hussman's thoughts but there is little to indicate that his strategy outperforms. The strategy being discussed, which basically amounts to buying insurance, looks great right now but we need to look at it from a long term point of view. Insurance always looks great right after a storm but that doesn't necessarily mean it is worth it in the long run.

Hussman's trailing 5 year total returns on his two funds are range between 3% to 5% (according to Morningstar.) He used to average over 10% per year in the early 2000's but it has been below 6% in the last few years. We need to wait a longer period before forming any conclusions but the returns don't seem spectacular to me. It has far lower volatility--if you don't want to see wild swings, it's a good fund--but the total returns don't seem great. I would guess that someting like Martin Whitman's Third Avenue Value Fund, which is down significantly this year, would still beat the hedged Hussman strategy if we look at it in 5 years.


Buffetterr17's strategy looks great because we are looking at it right after a huge collapse in the markets. It's no different than looking at all the 2x inverse bear funds and seeing 100%+ gain in practically all of them year. Note that if we assume the market goes up 10% per year on average, we are looking at these double short funds posting 10 years worth of returns in 1 year!!!

I am still not confident that it is attractive from a long term poitn of view. You will be paying, say 4% per year, during bull markets. Ignoring compounding, taxes, etc, that's like 32% in 10 years (if we assume a bull makret lasts 8 years and a bear market 2 years.) You would need the market to fall significantly (it doesn't fall 30%+ all the time) for it to be made up.

Having said that, Buffetteer, like Hussman and most market-neutral or long-short funds keep changing the hedged portion, so one can argue that the cost during a bull market won't be high (they will be more long.) But this involves a lot of market timing. Buffetteer luckily increased his hedge last year. What if he didn't? What if he bought all the puts, say middle of this year? Not only would he be entering the trade a bit late, the premiums on the puts would be much higher.


I think if someone wants low volatility or has good market timing skills, then long-short portfolio, as Buffetter and Hussman run, may be attractive. Otherwise I just don't see the benefit.

---------
Check out my investing blog - contrarian with a macro focus and a value investing tilt: Can Turtles Fly? A Contrarian Investing Blog.


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Re: Buffetteer17 and John Hussman, Ph.D.
Posted by: David Pinsen (IP Logged)
Date: October 29, 2008 11:35AM

Sivaram,

"Having said that, Buffetteer, like Hussman and most market-neutral or long-short funds keep changing the hedged portion, so one can argue that the cost during a bull market won't be high (they will be more long.) But this involves a lot of market timing."

When someone writes as precisely and carefully as Hussman, you need to read more closely. In Hussman's commentary, he explicitly notes that his equity fund isn't a market-neutral or long-short fund -- it's a hedged growth fund. He also notes that he doesn't try to time the market; he bases his level of hedging on market valuation metrics. From his commentary:

We aren't trying to catch a rally – we are gradually building an investment exposure based on valuations. Our investment response to undervaluation is straightforward: we establish investment exposure in proportion to the return/risk profile that we can expect from prevailing conditions, on average. At the 2002-2003 lows, stocks never got to the point of undervaluation, so we remained fully hedged until we observed a shift to favorable market action in the spring of 2003, at which point we quickly removed 70% of our hedges. In a market that has become undervalued, however, the strategy of waiting for a measurable improvement in market action historically has not performed nearly as well as a strategy of gradually increasing market exposure, on declines, as the market's valuation improves. Scaling in that way is certainly not comfortable, but the willingness to experience short-term discomfort is a scarce and ultimately well-compensated resource on Wall Street. The key is to scale gradually and in proportion to the expected return profile, rather than trying to “time” reversals that can't be predicted.

[...]

It is important that shareholders recognize that the Strategic Growth Fund is a risk-managed, equity growth fund, not a market neutral fund and not a bear fund. Our intent remains to outperform the S&P 500 over the complete market cycle, with smaller periodic losses than passive “buy and hold” investors would experience in the stock market. This intent is not consistent with minimizing or avoiding every risk, particularly as valuations and expected return prospects improve.


My signature: I blog at [steamcatapult.com]


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Re: Buffetteer17 and John Hussman, Ph.D.
Posted by: David Pinsen (IP Logged)
Date: October 29, 2008 11:50AM

"Hussman's trailing 5 year total returns on his two funds are range between 3% to 5% (according to Morningstar.) He used to average over 10% per year in the early 2000's but it has been below 6% in the last few years. We need to wait a longer period before forming any conclusions but the returns don't seem spectacular to me. It has far lower volatility--if you don't want to see wild swings, it's a good fund--but the total returns don't seem great. I would guess that someting like Martin Whitman's Third Avenue Value Fund, which is down significantly this year, would still beat the hedged Hussman strategy if we look at it in 5 years."

This is a comparison of Hussman's Strategic Growth Fund to Whitman's Third Avenue Value Fund. Change the year in the first box to 2000 to get the comparison since the inception of Hussman's equity fund. Hussman's cumulative return since then is about 40%; Whitman's (eyeballing the graph) is about -15%.



My signature: I blog at [steamcatapult.com]


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Re: Buffetteer17 and John Hussman, Ph.D.
Posted by: buffetteer17 (IP Logged)
Date: October 29, 2008 06:19PM

Sivaram: "I am still not confident that it is attractive from a long term point of view. You will be paying, say 4% per year, during bull markets."

I actually agree that keeping a hedge going long term would most likely reduce one's cumulative returns. The 4% estimate of the cost sounds about right.

However, my situation was special.

- I wanted to retire in 2009.
- I used margin.
- 90% of my investments were in common stocks (and call options).
- My portfolio cumulative return in 2007 was 30%/year. I felt that was not sustainable.

On reviewing the situation, I realized that I either had to hedge or move a significant fraction of my investments, say 1/3 to 1/2, to fixed income. Fixed income was sucking at the time. I chose the hedge.

I don't have a long term strategy for varying the amount of hedge depending on the market. I haven't been at it long enough. Hussman's sounds logical. I wouldn't call it "timing the market." Timing the market would be forcasting what the market will do in the near term. I can't do that and I don't believe many (if any) can. What Hussman seems to do is make a macro judgement of whether the overall market is over or under priced relative to fundamentals. That's not really market timing.



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