Investor Prem Watsa (Trades, Portfolio) has increased his portfolio hedges up to 100% of his equity investment portfolio since the start of the year to protect against volatility, he said Thursday.
The hedges represent an increase from an 88.1% equity hedge Watsa, the founder of insurance conglomerate Fairfax Financial Holdings (TSX:FFH, Financial) in Canada, had in place at year-end. The increase consisted of $938 million in short positions in equity and equity index total return swaps. Watsa said he made the move “in response to the significant appreciation in equity market valuations and uncertainty in the economy.”
Fairfax reported a $259 million net investment loss for the full-year 2015, with realized gains of $1.2 billion and unrealized losses of $1.4 billion. Including hedging gains and mark-to-market fluctuations, it had after-tax income of $568 million for the year.
“We are maintaining our defensive equity hedges and deflation protection, as we remain concerned about the financial markets and the economic outlook in this global deflationary environment,” Watsa said in a fourth-quarter conference call.
In a third quarter letter, Watsa said the positions shorted the Russell 200 Index, S&P 500, TSX 60, other indexes and individual stocks, and he also held put options against the S&P 500.
“The company's economic equity hedges are structured to provide a return which is inverse to changes in the fair values of the indexes and certain individual equities,” he said.
Watsa’s hedges date back to 2010. He increased the hedging on his common stock from 30% at the start of the year to roughly 100% by the end.
“Our view was twofold: our capital had benefitted greatly from our common stock portfolio and we wanted to protect our gains, and we worried about the unintended consequences of too much debt in the system – worldwide!” Watsa wrote in his 2010 annual letter.
“If the 2008/2009 recession was like any other recession that the U.S. has experienced in the past 50 years, we would not be hedging today. However, we worry, as we have mentioned to you many times in the past, that the North American economy may experience a time period like the U.S. in the 1930s and Japan since 1990, during which nominal GNP remains flat for 10 to 20 years with many bouts of deflation.”
The cost of buffering his portfolio against a market reversal has also weighed on his investing returns. In the three years preceding 2010, Watsa’s investment team earned gains averaging 14.3%. In 2010, they gained only 3.9%, with a 4.2% loss due to hedging.
Similarly, in 2014, Fairfax produced an 8.4% investment return, which would have been 9.8% without hedging.
“While our returns in 2014 were very good, we have some way to go to make up for the below average annual return of 3.6% over the past five years,” Watsa wrote in a letter. “Our cumulative net realized and unrealized gains since we began in 1985 have amounted to $11.7 billion.”
Some of Watsa’s long positions have also suffered recently, with his largest holding, smartphone maker BlackBerry Ltd. (BBRY, Financial), down 23%; his second largest, Resolute Forest Products (RFP, Financial) down 46%; and his third largest, Kennedy-Wilson Holdings (KW, Financial), down 30% year to date, versus a 5.9% decline for the S&P 500.
As of 2014, Watsa has compounded book value at Fairfax by 21.1% annually since its founding in 1985.
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