A New Approach For A New Year

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A New Approach To Portfolio Construction

Happy New Year, fellow Slopers. I know most of you are active traders, but for those of you managing money for loved ones who aren’t, this might be of interest.

With the New Year, it’s time to consider a new approach to portfolio construction. Unlike most forms of portfolio construction, Portfolio Armor‘s hedged portfolio method eschews diversification. It looks radical at first glance: instead of allocating your investor’s assets among dozens of individual securities, you put their money in up to 8 names, some of which may even belong to the same sector.

In a nutshell, you buy and hedge a handful of securities that have high potential returns net of their hedging costs.

Easier Said Than Done

The first step here is to find alpha, which is difficult enough, without other conditions. But with this method, you don’t just need to find alpha, but to find it among securities that aren’t too expensive to hedge. That’s a tall order. It’s taken years to develop a system to do that, but I think I have built a better mousetrap.

Let me prove it to you.

Delivering Alpha

For the hedged portfolio method to work, you need to be able to deliver alpha, because hedging is going to be a drag on performance in most cases. In my article introducing the hedged portfolio method I included data from backtests from 2003 to 2014 showing the alpha my security selection method delivers. I included that data, as well as interactive versions of the hedged portfolio backtests on this page of the Portfolio Armor site, where you can see exactly what the underlying security and option positions were at each point in time. But I know backtests are going to convince you, so here’s something else that might.

Starting on June 8th, I’ve been presenting Portfolio Armor’s top ten names each week to subscribers of this service, along with selected hedged portfolios. As each portfolio lasts 6 months (positions are held for 6 months or until just before their hedges expire, whichever comes first), I’ve been presenting results each week since earlier this month. These aren’t backtests, but positions and portfolios posted and then tracked in real time over the next 6 months. Here’s the performance of the top names from the first three weekly cohorts to complete:

June 8th Top Names

On These On average, the top names were up 8.78% from June 8th to December 8th, versus 9.99% for the SPDR S&P 500 ETF (SPY) over the same time period.

June 16th Top Names

On average, the top names were up 19.75% from June 16th to December 15th (December 16th was a Saturday), versus 10.94% for SPY over the same time frame.

June 22nd Top Names

On average, the top names were up 24.46% from June 22nd to December 22nd, versus 11.27% for SPY.

Hedged Portfolio Performance

Of course, delivering alpha in security selection is only the first hurdle. To deliver competitive performance in hedged portfolios, the alpha has to be enough to overcome the drag of hedging and trading costs. Fortunately, it often is (it helps that trading costs tend to be low, due to the the small number of securities in the portfolio). Although I’ve presented portfolios hedged against different decline thresholds, to compare apples to apples, I’ll show the performance below of three portfolios hedged against greater-than-9% declines created on the same dates above. You can use Portfolio Armor to create portfolios hedged against declines of as little as 2% over six months, but 9% is smallest decline threshold where you are likely to get some of Portfolio Armor’s top ten names in the portfolio: the tighter you want to hedge, the fewer hedgeable securities there are to choose from.

June 8th Hedged Portfolio

This was the $1,000,000 portfolio constructed of Portfolio Armor’s top names, hedged against a >9% decline on June 8th.

The worst case scenario for this portfolio was a decline of 8.51%; the best case scenario was a gain of 18.09%, and the ballpark estimate of expected return was 6.11%.

Note that the prices shown for the puts there were their asks, and the prices shown for the calls were their bids: to be conservative, we’re assuming you’re entering your hedging trades at the worst ends of their respective spreads.

June 8th Hedged Portfolio Performance

Although we assume you executed your options trades at the worst ends of their respective spreads, our performance tracker values options at the midpoint of their bid-ask spreads or their intrinsic values, whichever is higher. Because of that, and because of the trading fees we deduct, each portfolio starts in a slight hole, as you can see in the charts below, where Portfolio Armor’s value on the Y-axis is slightly below that of SPY, which is set at $1,000,000.

June 16th Hedged Portfolio

This was portfolio hedged against a >9% decline, originally presented here, along with the list of top names.

The worst case scenario here was a Max Drawdown of 8.49%, the best case scenario, a gain of 15.56%, and the Expected Return was 5.13%.

June 16th Hedged Portfolio Performance

June 22nd Hedged Portfolio Performance

This was the top names portfolio, hedged against a >9% decline, originally presented here, along with the list of top names.

The worst case scenario here was a Max Drawdown of 8.32%, the best case scenario, a gain of 20.3%, and the Expected Return was 6.52%.

June 22nd Hedged Portfolio Performance

Wrapping Up

As you can see in the June 8th example, these hedged portfolios — particularly the ones designed for investors with lower risk tolerances — aren’t always going to beat the market. But over time, they should deliver competitive performance. Most importantly, if you put your investors in one aligned with their risk tolerance, they will never be down more than their risk tolerance at the end of 6 months, regardless of what the market does. That means you won’t have to worry about your AUM crashing just because the market did.

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