Hey Fellow Slopers,
A quick apology for my being rusty at guest posting here at Chez Tim. It looks like my last post about the hedged portfolio method (“Does Hedged Investing Work?“) was missing an image of a sample hedged portfolio. I’ve included an image of one below. First though, a quick recap of what the hedged portfolio method is.
The Hedged Portfolio Method
The Portfolio Armor hedged portfolio method is a way of generating competitive returns with less risk than the market, by investing in a series of concentrated, hedged portfolios lasting about six months each. Here’s how one such series would have done, net of trading fees and hedging costs, over the period from 1/2/2003 to 4/30/2014.
A Current Example of a Hedged Portfolio
The hedged portfolio below was created at the close on Thursday, and was designed for an investor with $500,000 to invest who is unwilling to risk a drawdown of more than 20% over the next 6 months.
What it all means
Here’s an explanation of all the terms used in the hedged portfolio. If you have any questions, please fire away in the comments. Thanks for reading, and thanks to Tim for hosting.
EXPLANATION OF RESULTS
Potential Return: A bullish estimate of how a security might perform over the next six months, or for the duration of its optimal hedge, whichever time period is shorter. When hedges expire in less than six months, Portfolio Armor automatically adjusts down the potential return of the underlying security to account for the shorter time frame. At the portfolio level, potential return is an aggregate of the potential returns of the positions in the portfolio.
Cap: For securities hedged with optimal collars, the maximum possible return over the duration of the collar. If the security appreciates beyond this percentage, the owner of the call options you sold when you opened the collar will likely exercise them, “calling away” your shares. For securities used as cash substitutes, the cap will be set at 1% or the current 7-day yield on a leading money market fund, whichever is higher. For all other collared securities, the cap will be set at each security’s potential return. For an explanation of why we set the cap at the potential return see Boosting Returns. For any securities hedged with optimal puts, there will be no cap.
Hedging Cost: For securities hedged with optimal puts, this is simply the cost of the puts if you purchase them at their ask price. For securities hedged with optimal collars, this is the net cost of the collars – the cost of the long put leg at the ask price minus the income generated by the selling the call leg at the bid price. Note that Portfolio Armor uses the ask price of the puts and the bid price of the calls in its calculations to be conservative: in practice, you can often buy puts for less than their ask price (i.e., at some price between the bid and ask) and you can often sell calls for more than their bid price (again, at some price between the bid and ask). In cases where the income generated by selling the calls exceeds the cost of buying the puts, the hedging cost will be negative.
Net Potential Return: The lesser of the potential return and the cap minus hedging cost. For cash substitutes, this will be the cap minus hedging cost; for other securities hedged with optimal collars and optimal puts, it will be the potential return minus hedging costs.
Cash Substitute: A security that when hedged with an optimal collar with a cap set at 1% or the current 7-day yield on a leading money market fund, whichever is higher, has a maximum downside risk less than or equal to your threshold, a low hedging cost, and a net potential return greater than the current 7-day yield on a leading money market fund. Portfolio Armor includes cash substitutes when possible in portfolios to boost potential returns while limiting downside risk.
Expected Return: At the individual security level, this is a likely return, net of hedging costs, over the next six months or the duration of the hedge, whichever time period is shorter. At the portfolio level, this is a likely return for your portfolio over the next six months.
Max Drawdown: The worst-case scenario for this portfolio. If each of your hedged securities goes to zero before the hedges expire, this is how much your portfolio would decline.
Note: The results above are based on the following assumptions:
- You buy the underlying securities at or near their prices shown above.
- You buy the puts at or below the ask prices indicated.
- You sell the calls at or above the bid prices indicated.
- You hold the securities for six months, until shortly before their hedges expire, or until they are called away, whichever comes first.
