In a recent article, GuruFocus contributor Brian Bollinger asked if utility stocks are in a bubble. Whether they are or not is one question; another is, if they are in a bubble, when will it pop? Since it's impossible to know the answer to either question ahead of time, one approach utility investors may want to consider is to buy and hedge. To see why, consider the 10-year history of the UtilitiesSelect Sector SPDR ETF (XLU, Financial).
Over the last 10 years, the average six-month return of XLU has been 3.56%, but in one of those six-month periods during 2008, investors suffered a 27% drawdown. As we'll show below, by using the hedged portfolio method to invest in some of XLU's top holdings, an investor can get a similar expected return over the next six months while risking a drawdown less than half as large as the one mentioned above.
When stocks can be safer than an ETF
It may seem counterintuitive that you can be exposed to less risk by holding a handful of XLU components than by holding the ETF that owns many of them, but that can be the case when you own those stocks within a hedged portfolio. Although a diversified portfolio limits the idiosyncratic risk of owning individual stocks, it doesn't limit market risk. But a hedged portfolio limits both. Below, we'll show how to construct a hedged portfolio including some of XLU's top holdings for an investor who is unwilling to risk a drawdown of more than 13.5% and has $510,000 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 26% decline will have a chance at higher potential returns than one who is only willing to risk a 16% drawdown. In our example, we'll be using a 13.5% threshold (half of the 27% drawdown XLU investors experienced in 2008).
Constructing a hedged portfolio
We'll recap the hedged portfolio method here briefly and then explain how you can implement it yourself using XLU's top holdings as a starting point. 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 relatively high potential returns.
- 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 portfolio 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
If we were looking for securities with the highest potential returns,we wouldn't limit ourselves to just XLU components or utility stocks; instead, we'd consider a much broader universe of securities. But since we're concerned with Dow stocks here, we'll start with the top holdings of XLU. To quantify potential returns for XLU's top holdings, you can check GuruFocus for articles that offer price targets for thestocks, or you can use sell-side analysts' consensus price targets for them and then convert those to percentage returns from current prices. For example, via Nasdaq, this is the 12-month consensus price target for XLU holding PP&L Corp. (PPL, Financial):
You can use that consensus price target as a starting point for your estimate, adjusting it based on the time frame you're using and whether you think it is overly optimistic or not. 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 expected returns. Our method starts with calculations of six-month expected returns.
Finding inexpensive ways to hedge these securities
Our method attempts to find optimal static hedges using collars as well as protective puts going out approximately six months. Whatever hedging method you use, for this example, you'd want to make sure that each security is hedged against a greater-than-19% decline over the time frame covered by your potential return calculations. And you'll need to calculate your cost of hedging as a percentage of position value.
Select the securities with highest net potential returns
When starting from a large universe of securities, you'd want to select the ones with the highest potential returns, net of hedging costs; you can do the same here, starting with the top holdings in XLU, but, in any case, you'll at least want to exclude any of them that has a negative potential return net of hedging costs. It doesn't make sense to pay X to hedge a stock if you estimate the stock will return
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. To calculate expected returns, you need to have some idea of how your past potential return calculations compared to subsequent actual returns.
An automated approach
Here we'll show an example of creating a hedged portfolio starting out with XLU's top holdings using the general process described above, facilitated by the automated hedged portfolio construction tool at Portfolio Armor. These are the current top 10 holdings in XLU, via Fidelity:
- NextEra Energy (NEE, Financial)
- Duke Energy (DUK, Financial)
- Dominion Resources (D, Financial)
- Southern Company (SO, Financial)
- American Electric Power (AEP, Financial)
- Pacific Gas & Electric (PCG, Financial)
- Sempra Energy (SRE, Financial)
- Excelon (EXC, Financial)
- PP&L Corp.
- Public Service Enterprise (PEG, Financial)
Starting with those names, in the first step, we enter the ticker symbols in the "Tickers" field, the dollar amount of our investor's portfolio (510000), and in the third field, the maximum decline he's willing to risk in percentage terms (13.5).
In the second step, we are given the option of entering our own potential return estimates for each of these stocks, or leaving the fields blank and letting the site supply its own potential returns. In this case, we're going to leave those fields blank and let the site supply its own potential returns.
A couple of minutes after clicking the "Create" button, we were presented with the hedged portfolio below. The data here is as of Monday's close.
Why these particular securities?
The site calculated potential returns for each of the stocks we entered, and then, for the ones that had positive potential returns, it calculated the cost of optimally hedging them. Only the ones with positive potential returns, net of hedging costs – American Electric Power, PP&L and Southern – made it into the portfolio. Because the site normally includes six primary securities for a portfolio of this size, it added three of the securities with the highest net potential returns in its universe to the portfolio: Activision Blizzard (ATVI), Hawaiian Holdings (HA) and Advance Auto Parts (AAP). As it allocated cash to each of those stocks, it rounded down the dollar amounts to get round lots of each stock.
In its fine-tuning step, the site added Alphabet Inc. (GOOGL, Financial) as a cash substitute, to replace most of the cash leftover from the rounding-down process. Alphabet happened to have the highest net potential returns when hedged as a cash substitute, which is why it was selected. Let's turn our attention now to the portfolio level summary.
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 the hedges expired (a scary thought), the portfolio would decline 12.8%.
Hedging cost
The hedging cost in this case is 1.27%. However, as we note below, the hedging cost was calculated conservatively so the actual cost of hedging this portfolio would likely have been less.
Best-case scenario
At the portfolio level, the net potential return is 9.76% over the next six months. This represents the best-case scenario, if each underlying security in the portfolio meets its potential return.
A more likely scenario
The portfolio level expected return of 3.56% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns. As we noted above, the average six-month return for XLU over the last 10 years was 3.56% as well.
Each security is hedged
Note that each of the above securities is hedged. Alphabet, the cash substitute, is hedged with an optimal collar with its cap set at 1%; the other securities are hedged with optimal collars with their caps set at each stock's potential return, as calculated by the site. In our series of 25,412 backtests conducted over an 11-year period, the average actual return of a security hedged with an optimal put was 1.93x that of one hedged with an optimal collar so the site aims to hedge primary securities with optimal puts, if possible, unless their net potential returns, when hedged with collars, are >1.93x higher. In this case, all of the securities had >1.93x higher potential returns when hedged with optimal collars. Here's a closer look at the optimal put hedge on PP&L:
PP&L is capped at 2.03% here, because that's the potential return the site calculated for it over the next six months. As you can see at the bottom of the image above, the cost of the put leg of this collar was $1,540, or 2.12% of position value. However, if you look at the image below, the income generated from the short call leg of the collar was $1,650, or 2.27% of position value.
So the net cost of this optimal collar was 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 how a hedge on Skechers (SKX, Financial)Â reacted when that stock dropped 30% in one day recently.
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[i] To be conservative, Portfolio Armor calculated the hedging cost using the ask price of the puts and the bid price of the calls; in practice an investor can often buy puts for less and sell calls for more (for some price between the bid and the ask, in both cases). So, an investor opening this collar would likely have collected more than $110 when doing so. The other hedges in the portfolio were calculated in a similarly conservative manner, with the puts priced at the ask, and the calls priced at the bids, so the actual cost of hedging this portfolio would likely have been lower than shown.
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