The Hedged Returns Approach

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Happy New Year, fellow Slopers,

I’ve haven’t posted here as frequently as I would have liked recently, as I’ve been tied up putting the finishing touches on a soon-to-be-released Portfolio Armor website feature called Hedged Returns. Hedged Returns isn’t live just yet, but I thought I’d tell about it in this post, and, in my next post, give you some background details on the mechanics of it.

Maximizing your potential returns while minimizing your risk

Portfolio Armor’s Hedged Returns feature enables you to maximize your potential returns while limiting your downside risk to a drawdown of as little as 2%.

“Rule number 1: never lose money. Rule number 2: don’t forget rule number 2.”

–          Warren Buffett

The Trouble with Typical Investment Portfolios

Warren Buffet’s advice about not losing money is well known, but harder to implement. It’s impossible to invest without risking any losses, but typical investment portfolios often expose investors to the risk of large losses while offering low potential returns.

“I prefer to keep all my eggs in one basket and watch it carefully”

–          Warren Buffett

Typical investment portfolios don’t follow this bit of Buffett advice well either. They put their eggs in multiple baskets, ostensibly to limit risk. There are two problems with this sort of over-diversification. The first is that it doesn’t protect against systemic, or market risk. When the market crashes, as it did in 2008, nearly all stocks plummet, and most other asset classes decline as well (as gold, for example did).

The second problem is that high diversification dilutes potential returns[1][i]. Instead of having your money concentrated in a handful of investments with the highest expected returns, you have it diluted among many investments with subpar prospects.

The Hedged Returns Difference

Since each security is hedged, your potential downside is strictly and precisely limited, without the need for broad diversification or asset allocation. That means you can concentrate your assets in a handful of securities with the highest expected returns.

Higher Potential Returns and Lower Risk

Portfolio Armor offers you two ways to strictly limit your potential losses while maximizing your potential returns:

1)      Start with a clean slate. Just enter the dollar value of your portfolio, and the maximum drawdown you are willing to risk over the next six months (your “threshold”).  Portfolio Armor will draw from its universe of more than 3,000 stocks and ETFs and present you with an optimally hedged portfolio with the highest potential return given your risk tolerance and portfolio size.  Or,

2)      Start with your best ideas.  Enter the symbols of the stocks and ETFs you already own, or enter ones you’ve found via your own research on sites such as Slope+, Social Trade, or LikeFolio. Enter your own expected returns for each security, or let Portfolio Armor calculate them for you. Portfolio Armor will present you with an optimally hedged and allocated portfolio designed to maximize your potential returns given your current investments, risk tolerance, and portfolio size.

How it works:

Calculating Expected Returns

Every trading day, Portfolio Armor’s expected return calculator generates estimates of how more than 3,000+ stocks and ETFs will perform over approximately the next six months. These estimates are based on analysis of historical returns as well as option market sentiment, which provides a forward-looking element.

Scanning For Optimal Hedges

Next, Portfolio Armor scans for an optimal hedge for each security, using the maximum drawdown you are willing to risk as the decline threshold, and each security’s expected return as the upside cap. The idea here is to capture each security’s expected return while minimizing your downside risk. Then Portfolio Armor subtracts the hedging cost from each security’s expected return to find the net expected return.  The securities with the highest net expected returns are the ones Portfolio Armor draws from for its Hedged Returns portfolios designed to maximize potential returns.

Fine-Tuning Portfolio Construction

After identifying the securities with the highest net expected returns given the downside you are willing to risk, Portfolio Armor fine-tunes its selection based on the size of your portfolio to minimize costs and further maximize your potential return.  If you entered your own securities, Portfolio Armor will attempt to include them if their expected returns, net of hedging costs, are positive. If necessary, it will adjust position sizing to include them, and then use hedged cash substitutes to minimize leftover cash and increase your portfolio’s potential return.

An All-Weather Approach

Because its universe of more than 3,000 securities includes exchanged traded products (such as inverse ETFs) that can generate positive returns when the market declines, Hedged Returns can be used as an all-weather approach. During a bear market, the securities with the highest net expected returns may include bearish ETFs. Of course, you would be presented with optimal hedges for these, so if the market reversed direction while you held them, your downside risk would be strictly limited.

[i] The potential return of a Hedged Returns portfolio is how it will perform if each of its securities meets or exceeds its expected return.  The expected return of a security is an estimate of how it will perform over approximately the next six months.