Stopping by my local Starbucks on Tuesday, this was on the front page of the Star-Ledger:
A couple of embarrassingly Jersey items on the left, but in the middle is the typical advice offered to unhedged, long-only investors when the crap hits the fan. A better approach, I think, is for investors to be positioned in such away that they'll have no reason to panic, because their downside is strictly limited. That's the point of the hedged portfolio method.
Stocks for small hedged portfolio weather Tuesday's session
In a post written on Monday, but published Tuesday, ("Keeping a small nest egg from cracking"), I presented a hedged portfolio built for an investor with $30,000 who wanted to limit his downside risk to a drawdown of no more than 20% over the next six months. It turned out that the three stocks included in that portfolio, Facebook (FB, Financial), DexCom (DXCM, Financial), and Netflix (NFLX, Financial), all closed in the green on Tuesday, despite the market closing in the red.
Maximizing returns while limiting downside risk
The goal of Portfolio Armor's hedged portfolios is to maximize expected return over a six-month time frame while limiting downside risk, but it's interesting to see how the underlying securities do in a volatile environment (of course, if they do poorly, you're hedged, so your downside is limited). So I thought I'd run another $30k hedged portfolio, with the same parameters as the last one and we'll see how the names in this one hold up.
A hedged portfolio for a small investor willing to risk a drawdown of no more than 20%
Three positions, two stocks
This hedged portfolio only contains two different names, Netflix and Abiomed (ABMD, Financial), but ABMD is hedged in two different ways, once as a primary position, and once as a "cash substitute," 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 specification. Because they're hedged two different ways, the two ABMD positions have different expected returns.
Worst-case scenario
If both stocks go to zero before their hedges expire, this portfolio would be down no more than 19.29%. That's the "max drawdown."
Negative hedging cost
Note that it's negative for the portfolio as a whole, -1.58%, meaning an investor would collect more from selling the call legs of the collars on the three positions than he would pay for the put legs. To be conservative, Portfolio Armor calculates this cost using the ask price of the puts and the bid price of the calls; 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 hedging cost of this portfolio would likely have been lower (more negative).
Best-case scenario
If both stocks meet or exceed their potential returns, the portfolio would return 16.58% over six months.
More likely scenario
The expected return, 6.51%, represents a more likely scenario, based on the historical relationship between our calculated potential returns and actual returns (for more on that, see the Portfolio Armor site or this article ("Backtesting the hedged portfolio method").
Why those stocks
As of Tuesday's close, these were the five names with the highest potential returns net of hedging costs in the Portfolio Armor universe, along with their closing share prices on Tuesday:
- SKX - $131.96
- NFLX - $101.52
- REGN - $499.02
- ABMD - $93.88
- ANAC - $125.64
For a $30k portfolio (the site's minimum for a hedged portfolio), Portfolio Armor aims for including two primary securities and one cash substitute. It sticks to round lots to reduce hedging costs, so, with smaller portfolios, it picks stocks with relatively lower share prices from among the stocks with the highest potential returns.
