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How Should You Hedge Your Portfolio?

January 20, 2011

The stock market is probably overvalued, as indicated in GuruFocus broad market valuations. The Total Market Index is now at 92.6% of the GDP. This ratio is the “the best single measure of where valuations stand at any given moment”, as pointed by Warren Buffett. The market is positioned for mediocre long term returns, and most likely we are borrowing returns from the future, as noted by Dr. John Hussman, the founder of Hussman Economtrics Advisors, Inc.

This is the chart for the ratio of Total Market Index over GDP, updated daily:

Coincidentally, hedge fund giant David Tepper just told New York Post that 2011 will be "harder and not without risk." He continued "When things go up too high, they will go down," referring to the recent market surge.

What should you do at this point?

Of course you can go all cash and wait for better opportunities. That may not be a bad decision, it is what Warren Buffett did with his personal portfolio in 2006-2007, when the market was about 20% more overvalued than it is now.

Warren Buffett was lucky that he could put his money in much higher yielding treasury bonds or CDs in 2006. Today we don’t have this luxury as every safe investment yields close to nothing. You have a much higher risk of missing potential gains in the stock market if you are out. All of us have seen many times that the market went from overvalued to extremely overvalued. It can be painful to miss all the gains.

So you want to stay in the market? Then you need to be fully aware of the risks and possible outcomes at this level of market valuation. You probably need to be defensive with your portfolio.

Hedging seems to be an interesting idea at this point.

If you hedge your stock holdings with another group of securities that move in the opposite direction of the general market, the total performance of your portfolio will be the difference in the performances of your stocks and the hedges. If you are fully hedged, ideally your performance is de-correlated from the general market. You make money as long as your long positions gain more than the hedges, no matter how the general market does.

Like John Hussman, you can hedge your long positions with the index options that move in opposite direction of the general market. In this way your performance is equal to the outperformance portion of your stocks relative to the market. You can also hedge your portfolio by shorting a group of stocks that you think that will underperform the market. This is what many hedge fund gurus do: David Einhorn of Greenlight Capital, John Griffin of Blueridge Capital etc. Your gains come from both the outperformance of your long positions relative to the market, plus the gains from the underperformance of your short positions relative to the market.

This is what David Einhorn has been doing in 2010. He wrote in his latest shareholder letter: “…we generated a satisfactory result as our longs significantly outperformed the market, our shorts modestly underperformed the market (good for us), and our macro hedges, most notably gold, generated additional profits. The result was a full year net return that approximated the S&P 500, with very low correlation to the market and much less volatility.”

Of course, there is risk.

An example here is John Hussman. Thinking the market overvalued, John Hussman keeps his portfolio fully hedged through most of 2010. His stocks underperformed the market, he lost 3.6% with this fund in 2010 while the market gained more than 15%.

It can be worse if you hedge with long-short strategy. Your long positions may underperform the market, while your short positions gained more than the market. You lose in both directions. It can be painful.

The safer ways

If you believe that over long term, undervalued stocks always outperform the market, and overvalued stocks underperform the market, you may run a long-short strategy that long undervalued stocks and short overvalued stocks.

If one runs a portfolio by being long on the undervalued stocks and being short the same amount of overvalued stocks, the performance of the portfolio will be decided by the difference in the performances of the undervalued stocks and overvalued stocks. The shorted stocks serve as the market hedge, and the portfolio will be market neutral. The performances of the general market will not affect the returns of the portfolio. If the undervalued stocks gain more than the overvalued stocks when the broad market goes up, and lose less when the broad market goes down, this portfolio should deliver relative steady gains regardless how market goes.

As we discussed before, we created model portfolios of overvalued stocks after running the model portfolios of undervalued valued stocks for two years. The portfolio of Overvalued Predictable Companies consists of the top 25 stocks that have high predictability rank, but are most overvalued as measured by their intrinsic values; the model portfolio of historical high P/S ratios consists of the 25 highly predictable companies that are sold at historical high P/S ratios. We use these two model portfolios to hedge the model portfolios of undervalued stocks and predictable companies that are traded at historical low P/S ratios. We want to observe the performance differences of the undervalued stocks and the overvalued stocks. We want to see whether we can hedge the market risk by being long with relatively undervalued stocks and short with overvalued stocks.

So far so good! As of yesterday, our undervalued predictable model portfolio underperformed by the market by 0.67% since rebalanced on Jan. 1, but the overvalued predictable companies underperformed much more, by 3.04%. Therefore a fully hedged long-short strategy gains 2.37%, almost uncorrelated with the market.

The model portfolios of historical low/high P/S companies did even better. The model portfolio of historical low P/S companies outperformed by 0.66% this year, and that of historical high P/S underperformed by 2.26%. Therefore a fully hedged P/S strategy gains 2.92%.

Time is still too short for us to conclude for the strategies. But as value investors, we do believe that over long term, stock valuations will be back to their historical means. Undervalued stocks will outperform, while overvalued stocks will underperform.

To access the model portfolios and their corresponding stock screeners and look into this hedging strategy, a premium membership is required. As always, if you are not a premium member yet, we invite you for a 7-day Free Trial of the premium membership.

About the author:

Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 2.9/5 (30 votes)


Random_walker - 6 years ago    Report SPAM
Is shorting stocks simply on valuation measures a good strategy?
Adib Motiwala
Adib Motiwala - 6 years ago    Report SPAM
Good point. I doubt its a good idea to short based on valuation alone. It will be good to see the results of the model portfolios over a period of 2-3 years.
Gurufocus premium member - 6 years ago
The shorting here is not for the sake of shorting. We are trying to protect the portfolio from the market overvaluations.

In reality, the percentage of the hedging can be adjusted. You rarely 100% hedge. David Einhorn has a net long of 30% now.

We may elaborate more on this later.


Ungoat - 6 years ago    Report SPAM
I'm not sure (I don't short), but wouldn't you pay significant interest in order to short?

For instance, if you are 100% long, and also 100% hedged by short positions, wouldn't you pay interest to your broker on your full account value?

If on the other hand you were 50% long & 50% short, then you would only capture 1/2 the difference between your long and short positions as gains.

And if you hedge with options, then while you are not charged interest, you instead pay regular premiums, and time decay constantly eats away at you, which is really not much different than paying interest.
Gurufocus premium member - 6 years ago

you don't pay any interest as long as you make money on shorts. You do need to pay back the dividends though.

You don't really do 50% long and 50% short. For instance, if you have $1 million in cash. You can buy all this $1 million into long, you short $1 million stocks. This is a 100% long and 100% short scenario. You don't pay any interest as long as the value of the stocks you short is under $1 million. Actually, if the value of the short stocks go to $900,000, you make $100,000, and your broker will really put $100,000 into your account.

Of course, if the market goes up, or you shorted wrong stocks, the value of your shorts goes to $1.1 million, you need to have $100,000 cash in your account. Otherwise you have $100,000 in margin, and you have to pay interest on that $100,000. But if you do have $100,000 cash in your account, you still don't pay interest.

That is how a lot of hedge gurus do 100% long and 70% short.



Becomingbuffett - 6 years ago    Report SPAM

You guys have been busy the last several months--changing the look of the site, introducing new tools, overhauling the Ben Graham & Buffett-Munger newsletters . . . All good stuff!

This long/short exercise is going to be interesting to watch. (I learned quite a bit from this article.)

Anyway, just wanted to say thanks for all your work. This site is definitely the web's best destination for value investors!

Gurufocus premium member - 6 years ago
Thank you very much for your compliment. We are always dedicated to do our best. If you have suggestions, please feel free to let us know.

In the next few articles we will elaborate more on hedging.

Also by the way, thank you for subscribing our premium membership, which makes it possible for us to do better.

David Pinsen
David Pinsen - 6 years ago    Report SPAM
Speaking of hedging, Seeking Alpha published an interview about the hedging tool Portfolio Armor this week: Portfolio Armor: Optimized Downside Protection for Your Stocks and ETFs. Below is an excerpt, and below that, a special deal on Portfolio Armor.

This week, we (SA) interview David Pinsen (DP) of Launching Innovation LLC – whose Investing Tool, Portfolio Armor, helps provides optimal downside protection for stocks and ETFs in your portfolio.

And now, the interview:

SA: How does Portfolio Armor differ from other options tools?

Portfolio Armor is unique in that it shows the optimal put options to buy for you to obtain the precise level of protection that you want at the lowest cost.

SA: What about calculating Black-Scholes or another options pricing model in an Excel spreadsheet instead?

DP: The Black-Scholes formula is used to compute prices and hedge ratios for options. It will not tell you which contracts provide the optimal level of protection to preserve your wealth in a stock or ETF holding, given the market prices.

Options pricing models such as Black-Scholes give hedge ratios which require continuous and dynamic re-balancing of the hedge portfolio. Portfolio Armor maintains a static and conservative hedge ratio, and by taking the cost of the options into account, does so in the most economical way for the investor.

SA: What about just scanning Yahoo! Finance or Morningstar to manually find puts to buy?

DP: A very good, experienced and savvy investor might be able to find the right number of contracts and the right strike price to protect against a certain loss level, but when taking price into account he might be at risk of paying too much for too little coverage.


SA: Are there certain positions that are more catered to options protection than others? Have you run any studies as to the net/net effect of investing naked vs. using options to protect positions?

Some positions are certainly less expensive to hedge than others. Index ETFs such as DIA and SPY generally are cheaper to hedge than individual stocks, and more volatile stocks tend to be more expensive to hedge than less volatile ones.

I haven’t run studies comparing un-hedged investing versus hedged investing, but I suspect that over the course of a secular bull market, un-hedged investing would outperform hedged investing; and, conversely, over the course of a secular bear or range-bound market, an opportunistically hedged portfolio would outperform an un-hedged one. John Hussman comes to mind here again. He launched his Strategic Growth Fund, which is hedged, in 2000, near the beginning of the current secular bear, or range-bound market. It has outperformed the S&P-tracking ETF SPY over that time frame.

I suspect though that a similarly hedged fund would have underperformed SPY over a ten year bull market.

Charles Schwab is sponsoring this special deal below on Portfolio Armor. I think this deal will be available until next Wednesday.

    Original Price: $24.00 / month | Special Price: $0.99 / month

Batbeer2 premium member - 6 years ago
If you believe that over long term, undervalued stocks always outperform the market, and overvalued stocks underperform the market, you may run a long-short strategy that long undervalued stocks and short overvalued stocks.

An overvalued stock to short/hedge with: http://www.gurufocus.com/news.php?id=121352
Buffetteer17 premium member - 6 years ago
I've been using a mixture of index shorts and specific stock shorts to create an approximately market neutral portfolio. To create an index short I sold calls and bought puts against the S&P 500 index. One thing to watch out for, which I learned the hard way (I was down 11% last year): be wary of having more downside protection (long puts) than upside (short calls). The reason is, the time decay of the option premiums. When you are long this works against you, and when you are short it works for you. If your hedge is too heavily weighted towards the long side, it will cost you if the market goes up fairly steadily. You never get an opportunity to cash those long puts and they eventually expire worthless.

Nowadays I mostly have equal absolute dollar amounts of long and short options, which is nice because the money from the short options roughly pays for the long options. Following N. Taleb, I do infrequently buy a few extra far out-of-the-money puts when they go on sale for disaster protection. These can be had for pennys now and then, and you should consider them as fire insurance payments. The money is gone, they're almost sure to expire worthless, but if the market crashes hard, they suddenly get very valuable.

Having a few strike 800 S&P 500 index options in early 2009 saved my butt. I bought them for around $5 and cashed in 2/3 of them for around $150. The other 1/3 eventually expired worthless (if I had known at the time that Mar. 2009 was the bottom, I would have cashed them all, of course. But my crystal ball seems to be full of fog). Nowdays I have a handful of strike 1000 and strike 750 index puts, just in case, which cost about 1% of my portfolio value to purchase.
David Pinsen
David Pinsen - 6 years ago    Report SPAM

I remember your great hedging call in '08-'09.

Have you considered constructing a market neutral portfolio with long and short equities, instead of options?
Cm1750 - 6 years ago    Report SPAM
Buffetteer, while hedging has it's place and you made a great call in 2008-2009, wouldn't basing investments on expected absolute returns be just as good for a long-term investor?

If I think ABT, JNJ, WMT, PEP etc. are cheap stocks, shouldn't I just have 50% of my portfolio in these stocks and then wait until the market gets cheaper to utilize the rest of the cash?

Better yet, have your money in "cheap" stocks and then write some significantly OTM puts on others at very favorable strikes? That way you earn a decent return on your cash while waiting.

I realize 2008-9 brought down all stocks regardless of their valuation, but that would be a great time to utilize the cash reserve.
Superguru - 6 years ago    Report SPAM
I have been debating for some time if I should hedge or just move to higher % of cash.

As my stocks start hitting fair value in this bull market and I am selling them and I am not finding any investing opportunity, my cash % is increasing.

(It sounds like market timing but it is not)

Hopefully, I will be mostly cash a year or two before bull run ends and when next crash of century happens in 2015 - 2017. That only If I can keep my buy and sell discipline. These once in lifetime recession/crash events happen with regularity.

Buying some cheap insurance against large market declines does make sense as Buffetteer said -

"Nowdays I have a handful of strike 1000 and strike 750 index puts, just in case, which cost about 1% of my portfolio value to purchase"
David Pinsen
David Pinsen - 6 years ago    Report SPAM
A commenter on that interview I linked to above made an interesting suggestion: backward put spreads. According to him, these could net a small profit in up markets, and still provide protection against serious corrections (while losing money during smaller declines).
Random_walker - 6 years ago    Report SPAM
Backward put spreads sound good in theory but I'm struggling to find a trade on the S&P500 where I don't lose quite a bit of money during the smaller declines. Examples of potential trades with P&L scenarios would be greatly appreciated.

Buffetteer17 premium member - 6 years ago
Shorting is very hard. I've lost a lot while learning (UAL short was a disaster). The trouble with using a long/short stock mixture as a hedge is that the stocks you'd like to short are often momentum stocks that end up having a very high, but variable beta. About 30% of my portfolio is short specific stocks, and that's probably too much. I often get daily fluctuations of total portfolio on the order of 5% when the market moves less than 1%. Those are hard to ignore. There's no way to determine if you are truly market neutral or not.
David Pinsen
David Pinsen - 6 years ago    Report SPAM
You might want to ask the fellow in the comments there whether he can offer any examples.

Backward put spreads sound good in theory but I'm struggling to find a trade on the S&P500 where I don't lose quite a bit of money during the smaller declines. Examples of potential trades with P&L scenarios would be greatly appreciated.

David Pinsen
David Pinsen - 6 years ago    Report SPAM

The fellow I know who runs a market neutral portfolio doesn't aim for 100% market neutrality. He starts out that way (with 50% long and 50% short in each paired long and short position), but doesn't adjust positions while the trades are open. Still, he says he's able to cancel out up to 98% of market risk with his strategy.
Taowave - 6 years ago    Report SPAM
Hi Random Walker,

You ask a very very good question,and there are startegies that will protect you,but one first define what level of protection they seek.One suggestion I have is to see if the CBOE is still trading" binary options"


In my prior life,I was the head trader of equity derivatives at 2 major banks on Wall Street,and IMHO,this was one of the ways one could have the best of both worlds as a hedge.In particular,look at knockout/knockin options.The real question is,should they still be traded,how wide is the bid offer spread?

With that said,I would not reccomend trading "put backspreads".It is a bit messy, and most will not know the proper size to place,when and if to hedge and as you noted,will bleed to death on a slow move.Also,due to the skew,the put options you buy trade at a higher vol that the ones you sell.

If you are a value trader who feels comfortable scaling in as the market trades lower,I would look at collar type positions,but buying a wide put spread and selling a call/calll spread to finance it as opposed

to buying the naked put.Obviously,in the crash you will rue that day you buy the spread,but in "normal corrections "as much as 20%,you will be OK.Most importantly,theta may be on your side...Any questions feel free to ask.

Backward put spreads sound good in theory but I'm struggling to find a trade on the S&P500 where I don't lose quite a bit of money during the smaller declines. Examples of potential trades with P&L scenarios would be greatly appreciated.
Zevon - 6 years ago    Report SPAM

After stuffing my portfolio with over-priced Put Options - I discovered Portfolio Armor mentioned here. It looks PERFECT for an options idiot like me - but lacks functionality for:

- Selecting options for spreads, collars, or directional trading.

- Lacks the ability to daily monitor and adjust positions as needed, ensuring optimal profitability.

If you learn of other apps that are just as easy? Yet - AND such more functionality?


Drop me a line!


- Tom
David Pinsen
David Pinsen - 6 years ago    Report SPAM
Thanks Tom

We are considering adding collar functionality to Portfolio Armor in the future. Probably won't add anything related to directional trading, as Portfolio Armor is designed for hedging. Perhaps we could design another tool for that.

The web version of Portfolio Armor does give you the ability to save, track, and monitor positions -- and be notified via e-mail when securities drop below the thresholds you set, as well as when your options are nearing expiration. Portfolio Armor maintains a static and conservative hedge ratio, though, so it does not require continuous adjustment.

Superguru - 6 years ago    Report SPAM
"Still, he says he's able to cancel out up to 98% of market risk with his strategy." - DaveinHackenSack

What kind of returns do you get over a cycle if you cancel market risks by hedging versus if you do not hedge ?

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