Tag Archives: cash

There Is No Margin Of Safety

Summary Value investing’s “margin of safety” is illusory: “50 cent dollars” can turn into “50 cent quarters”, or worse. You can use value investing in security selection, but to protect against stock-specific risk, you need to diversify or hedge. An advantage of hedging is that it let’s you concentrate your assets in a handful of stocks you think will do best, while limiting your downside risk. An additional advantage of hedging is that it protects against market risk, which diversification alone does not. We outline a method for creating a hedged portfolio of value stocks, and provide an example. The Margin of Safety in Value Investing One of key terms used in value investing is ” margin of safety “, which refers to difference between a company’s market price and its ” intrinsic value “, as illustrated by the image below (take from the website of Pratt Capital, LLC) Margin of safety was coined by the putative father of value investing, Benjamin Graham, and perhaps the best way to help explain it is quote one of his famous sayings, “In the short run, the market is a voting machine, but in the long run, it’s a weighing machine”. “Voting”, or investor sentiment, drives the market price in the short term, according to Graham, but “weighing”, or recognition of intrinsic value, drives the stock price in the long term. The idea is, essentially, to buy a stock when it’s trading for less than it’s really worth (its intrinsic value), and sell it at some future date when it’s trading at its intrinsic value or higher. The Margin of Safety in Reality Buying a stock for less than your estimation of its intrinsic value and selling it for more later – value investing, in a nutshell – makes perfect sense. What doesn’t make sense is calling that discount between the market price and your estimation of intrinsic value a “margin of safety”, because it isn’t one. Let’s take the simplest case, what Graham referred to as a ” net-net “, a stock trading for less than its net current assets minus its total liabilities. In Graham’s day, these were more common, but you can still find them occasionally today among very small stocks. A stock trading for 50 cents per share with $1 per share in net current assets minus total liabilities would be a classic “50 cent dollar”. A can’t lose proposition, right? Well, not quite. One problem with a so-called 50 cent dollar is that you really don’t know what the net current assets are now ; you only know what they were as of the date they were reported. What if next time the company reports they have only 50 cents in net current assets per share? All else equal (i.e., the same conditions causing it to sell at discount in the past still applying) the share price will tank. And all else may end up being worse. Diversification versus Margin of Safety Of course, Graham knew this, which is why he advocated buying a basket of net-nets, rather than just a few. The basket — i.e., diversification — was his real downside protection against the stock-specific risk of some of his 50 cent dollars turning out to be a 50 cent half dollars, or, worse, a 50 cent quarters. One could argue that value investors today using more subjective measures of intrinsic value based on estimates of future earnings should be even more concerned about downside protection, particularly after some prominent value investing debacles during the last financial crisis. The Limits of Diversification Although diversification protects against stock-specific risk, it doesn’t protect against market risk. When the market tanks, nearly all stocks tank too. We saw this in miniature last month, as we noted in an article published soon after (“Lessons from Monday’s Market Meltdown”), and of course we saw it in 2008 , when stocks were a sea of red across the globe. What offers protection against market risk is hedging. Hedging Against one Kind of Risk or Both You can use a diversified portfolio to limit your stock-specific risk, and hedge against market risk by buying optimal puts on relevant index ETFs. We offered a step-by-step example of that in a previous post (“Protecting A Million Dollar Portfolio”). Alternatively, you can hedge each security you own; if you do that, you are hedging against both market risk and stock-specific risk, so you’ve obviated the need for broad diversification. That enables you to aim for maximizing your potential return with a concentrated, hedged portfolio. You can still use value investing principles to construct that portfolio, but you won’t be relying on an illusory “margin of safety” to protect it. We demonstrate a way of doing that below. 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 25% decline will have a chance at higher returns than one who is only willing to risk, say, a 15% drawdown. For the purposes of this example, we’ll split the difference and create a hedged portfolio designed for an investor with $250,000 who is willing to risk a drawdown of no more than 20%. Constructing A Hedged Portfolio We’ll summarize process the hedged portfolio process here, and then explain how you can implement it yourself. 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 high potential returns (we define potential return as a high-end, bullish estimate of how the security will perform). 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 portfolios 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 In this case, we’re going to use a large cap value screen from Zack’s Investment Research, but you could also use value stock ideas from Seeking Alpha or Seeking Alpha Pro . To quantify potential returns for these stocks, you can, for example, use analysts’ price targets for them and then convert these to percentage returns from current prices. 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 potential returns. Our method starts with calculations of six-month potential returns. Finding inexpensive ways to hedge these securities First, you’ll need to determine whether each of these top holdings are hedgeable. Then, whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-20% decline over the time frame covered by your potential return calculations (our method attempts to find optimal static hedges using collars as well as protective puts going out approximately six months). And you’ll need to calculate your cost of hedging as a percentage of position value. Selecting the securities with highest net potential returns In order to determine which securities these are, out of the list above, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you’ll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and exclude any security that has a negative potential return net of hedging costs. Fine-tuning portfolio construction You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs, so if you’re going to include a handful of securities from the sort in the previous step and you have a relatively small portfolio, you’ll need to take into account the share prices of the securities. Another fine-tuning step is to minimize cash that’s leftover after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won’t need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method searches for what we call a “cash substitute”: that’s 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 specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step. 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. In a series of 25,412 backtests over an 11-year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns. An Automated Approach Here we’ll show an example of creating a hedged portfolio starting with value stocks using the general process described above, facilitated by the automated hedged portfolio construction tool at Portfolio Armor . Narrowing Down Our List of Stocks To get a starting list of value stocks, we used the Large Cap Value screen created by Zack’s Investment Research in Fidelity ‘s stock screener. That screen uses these criteria: Market capitalization of $5 billion and above Projected EPS growth (quarter over quarter) of 17% or more Projected EPS growth (year over year) of 17% or more P/E below 12 PEG below 1 Security price above $5 Average volume over 50,000 shares traded daily On Thursday, that screen generated these 11 stocks: American Airlines Group (NASDAQ: AAL ) Citigroup (NYSE: C ) Delta Air Lines (NYSE: DAL ) Ford Motor Co. (NYSE: F ) Gilead Sciences (NASDAQ: GILD ) HollyFrontier Corp (NYSE: HFC ) Lear Corp (NYSE: LEA ) Southwest Airlines (NYSE: LUV ) Tesoro Corp (NYSE: TSO ) United Continental Holdings (NYSE: UAL ) Valero Energy (NYSE: VLO ) Using the Automated Tool In the first step, we enter the eleven ticker symbols in the “Tickers” field, the dollar amount of our investor’s portfolio (250000) in the field below that, and in the third field, the maximum decline he’s willing to risk in percentage terms (20). In the second step, we are given the option of entering our own potential return estimates for each of these securities. Instead, in this case, we’ll let Portfolio Armor supply its own potential returns. Note that the site’s potential returns are calculated based on price history and option market sentiment, so they generally won’t be very high for value stocks. But, again, you can enter your own potential returns in this step if you want. A couple minutes after clicking the “Create” button, we were presented with the hedged portfolio below. The data here is as of Thursday’s close. Why These Particular Securities? The site included all of the entered securities for which it calculated a positive potential return, net of hedging costs. In this case, that turned out to be six of the eleven stocks we entered, DAL, GILD, HFC, LEA, TSO, and VLO. In its fine-tuning step, it added Under Armour (NYSE: UA ) as a cash substitute. Let’s turn our attention now to the portfolio level summary for a moment. 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 their hedges expired, the portfolio would decline 19.8%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -2.56%, meaning the investor would receive more income in total from selling the call legs of the collars on his positions than he spent buying the puts. That also means that if the underlying securities returned 0% over the next 6 months, and the hedges expired worthless, the portfolio would return 2.56% (to be prudent, we suggest exiting positions just before their hedges expire instead). Best-Case Scenario At the portfolio level, the net potential return is 6.32% over the next six months. This represents the best-case scenario, if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 2.22% represents a conservative estimate, based on the historical relationship between our calculated potential returns and backtested actual returns. By way of comparison, a hedged portfolio created recently using the same decline threshold (20%), but without entering any ticker symbols (i.e., letting Portfolio Armor pick all the securities), had an expected return of 6.1%. You can see that hedged portfolio in a recent article (“Investing While Guarding Against Extensive Vertical Losses”). Each Security Is Hedged Note that each of the above securities is hedged. Under Armour, the cash substitute, is hedged with an optimal collar with its cap set at 1%, and the remaining securities are hedged with optimal collars with their caps set at each underlying security’s potential return, as calculated by the site. Here is a closer look at the hedge for Gilead Sciences: Gilead Sciences is capped here at 10.62%, because that’s the potential return Portfolio Armor calculated for it over the next several months. As you can see at the bottom of the image above, the cost of the put protection in this collar is $464, or 2.08% of position value. But if you look at the image below, you’ll see the income generated from selling the calls is $640, or 2.87% of position value. So, the net cost of this optimal collar is -$176, or -0.79% of position value, meaning the investor would collect more income from selling the calls than he paid to buy the puts.[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 this instablog post on hedging the iPath S&P 500 VIX ST Futures ETN (NYSEARCA: VXX ). [i]To be conservative, this optimal collar shows the puts being purchased at their ask price, and the calls being sold at their bid price. In practice, an investor can often buy the puts for less (i.e., at some point between the bid and ask prices) and sell the calls for more (again, at some point between the bid and ask). So the actual cost of opening this collar would have likely been less. That’s true of the other hedges in this portfolio as well. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

3 Mutual Funds To Buy If Fed Opts For Rate Hike

In our Mutual Fund Commentary yesterday we spoke about funds in focus if the U.S. Fed decided against a rate hike as soon as September. Utilities funds demand attention then as low interest rate environment, which has for sometime been near a zero level, has been extremely conducive for its growth. The capital intensive utilities industry needs to access external sources of funds to expand its operations. While it remains too close to call, today let’s look at funds that investors may immediately add to their portfolios if the Fed announces rate hike. Amid the market volatility, the Fed seems to be stuck between global central banks’ easing measures, dollar strengthening, deflationary pressures arising from the energy sector and troubles in the global economy. While most polls recently turned against a September rate hike, a recent CNBC survey shows that 49% predict a rate hike now. We do not rule away the chances of a rate hike completely, may be by 0.25%, but uncertainty is what is ruling the roost. Whether lifting the monetary policy stimulus would be a prudent move is the question that the Fed needs to answer. The two-day Federal Open Market Committee’s policy meeting ends today. The finance sector, in this regard, seems to be a good bet, as several industries including insurance, banking, brokerage and asset managers tend to benefit from the rising rates. Before we pick the funds, let’s look at some other details. CNBC Survey Goes Against Other Polls According to a CNBC survey, 49% of respondents out of 51 economists are projecting a rate rise now. This data as of Sep 16 is in line with predictions on Aug 25. On the other hand, those believing in a delayed rate hike dropped to 43% from 47% on Aug 25. The rate has increased for those who are unsure, as the percentage is at 8% as of Sep 16 compared with 5% on Aug 25. They predict that the Fed will finish hiking rate in this cycle, or take it to “terminal rate” in the first quarter 2018. This brings the prediction forward by six months. Separately, most are of the view that markets have priced in the hike. While 56% believed its priced into stocks, 60% said its priced into bonds. However, the Standard & Poor’s 500 is estimated to finish 2015 at 2,032, lower that prior projection of 2,135. Meanwhile, a Reuters poll shows that 45 respondents out of 80 economists believe that the Fed will leave its benchmark interest rate between zero and 0.25%. Only 35 respondents expected a rate rise. Looking at the primary dealers or economists from banks dealing directly with the Fed, 12 banks see no rate hike now as against 10 expecting a rate hike. Financials to Gain While Deutsche Bank believes they expect a “hawkish hold,” stance, UBS chairman Axel Weber is expecting a rate hike. He said: “The underlying economic data in the U.S. warrants a rate hike. The U.S economy can stand it. The U.S. economy in my view actually needs it medium- to long-term and I’m pretty convinced that the U.S. will see a rate hike, most likely in September.” The financial sector will be among those which will gain if a rate hike occurs. One particular beneficiary of higher rates is the insurance industry. This is because they take in premiums from customers, invest them — usually in fixed income securities — and then pay out claims in the future. Also, brokerages earn interest income on un-invested cash in customer accounts. So when rates rise, they can invest this cash at higher rates. Banks may benefit from rising interest rates, as long as long-term rates move up more than short-term rates. Banks derive benefits from a steep yield curve, i.e. when the spread between long-term and short-term rates is wide. The interest rates on deposits are usually tied to short-term rates while loans are often tied to long-term rates. This means that the potential rise in rates will enable the banks to charge more for loans, leading to an increase in the spread between lending rates and the rates paid on deposits. Moreover, an improving economy means that credit quality will likely improve, which will also aid banks’ profitability. Insurance companies invest majority of the premium income received from policyholders in government and corporate bonds to earn investment income. They utilize this investment income in meeting their future commitments to policy holders. The potential rise in rates will allow the insurance firms to invest their new premium income in higher yielding securities, thereby leading to higher future returns. With a rise in rates, brokerage firms are likely to engage in more investment activity. Brokerage firms earn interest income on un-invested cash in customer accounts. The rise in rates will allow the brokerage firms to invest at higher rates. Further, asset managers can position themselves favorably with the rise in rates. In the fixed income sector, default rates are likely to decline and higher interest rates will enable reinvestment at higher yields, which ultimately will boost portfolio returns. The benefit can be achieved by positioning fixed income portfolios strategically through proper management of duration, diversification of sources of yield and maximize the reinvestment of income. 3 Financial Mutual Funds to Buy Below we present 3 Financial mutual funds that carry either a Zacks Mutual Fund Rank #1 (Strong Buy) or Zacks Mutual Fund Rank #2 (Buy). We expect the funds to outperform its peers in the future. Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but the likely future success of the fund. The funds have encouraging year-to-date, 1-year and 3 and 5-year annualized returns. The minimum initial investment is within $5000. These funds also have low expense ratio and carry no sales load. Emerald Banking and Finance Fund A (MUTF: HSSAX ) seeks long-term growth through capital appreciation. Income is a secondary objective. HSSAX generally invests at least 80% of its net assets in common stocks. Emerald Banking and Finance’s managers limit the fund investment to 50 companies and the fund invests primarily in U.S. based companies. HSSAX currently carries a Zacks Mutual Fund Rank #2. It boasts year-to-date and 1-year returns of 11.9% and 18.3%. The 3 and 5 year annualized returns are 20.1% and 18%. Annual expense ratio of 1.60% is however higher than the category average of 1.52%. Moreover, HSSAX also has low beta score. The 1, 3 and 5 year beta scores are 0.58, 0.63 and 0.75. Franklin Mutual Financial Services Fund A (MUTF: TFSIX ) seeks capital growth. TFSIX invests a lion’s share of its assets in undervalued companies that are involved in the financial services domain. TFSIX may also invest in merger arbitrage securities and securities of distressed companies. TFSIX currently carries a Zacks Mutual Fund Rank #2. It boasts year-to-date and 1-year returns of 4% and 7.3%. The 3 and 5 year annualized returns are 13.9% and 11.2%. Annual expense ratio of 1.44% is lower than the category average of 1.52%. Moreover, TFSIX has 1, 3 and 5 year beta scores of 0.81, 0.83 and 0.70. John Hancock Regional Bank Fund B (MUTF: FRBFX ) invests most of its assets in equities of regional banks and lending companies. These may include commercial banks, industrial banks, savings and loan associations, financial holding companies, and bank holding companies. FRBFX may also invest in other U.S. and foreign financial services companies. A maximum of 5% may be invested in stocks outside the financial services domain. FRBFX currently carries a Zacks Mutual Fund Rank #2. It has year-to-date and 1-year returns of 2.2% and 8%. The 3 and 5 year annualized returns are 14.3% and 13.2%. Annual expense ratio of 1.98% is however higher than the category average of 1.52%. Moreover, FRBFX has 1, 3 and 5 year beta scores of 0.62, 0.65 and 0.88. Link to the original article on Zacks.com

Building A Hedged Portfolio Of Governance Metrics International’s Top-Ranked Stocks

Summary A way to potentially boost your returns when building a concentrated portfolio is to start with stocks that are rated highly by quantitative analysis. The Governance Metrics International, or GMI, rating system uses quantitative analysis to assess financial reporting and corporate governance, and determine which stocks are likely to substantially outperform the market. With any quantitative system, there’s a risk the analysis will be wrong, or the market will move against you. Using the hedged portfolio method can limit your downside risk. We show how to create a hedged portfolio starting with top-rated GMI stocks, and provide a sample hedged portfolio designed to limit downside risk to a 20% drawdown. In the Wake of Enron, A Focus On Financial Reporting One of the forensic accounting firms founded in the wake of Enron’s fraud was Audit Integrity, which later changed its name to Governance Metrics International (GMI), and was acquired by MSCI ‘s ESG Integration Unit last year. GMI uses a proprietary quantitative approach to analyze the financial reports and governance practices of public companies. The best-known indicator GMI uses is its Accounting and Governance Risk ( AGR ) ratings, which range from “Very Aggressive” to “Conservative.” According to GMI, companies rated “Very Aggressive” are 10 times more likely to face SEC enforcement actions than those rated “Conservative,” and 4 times more likely to file for bankruptcy. GMI uses its AGR ratings to derive its AGR Equity Risk Factor, which it considers to be a leading indication of share performance. AGR Equity Risk Factor ratings range from 1 (“Substantially Outperform Market”) to 5 (“Substantially Underperform Market”). We’re going to start with the universe of GMI’s 1-rated stocks to build a concentrated, hedged portfolio. Why a Concentrated Portfolio The point of a concentrated portfolio is to invest in a handful of securities with high potential returns, instead of a larger number of securities with lower potential returns. As Warren Buffett noted in a lecture at the University of Florida’s business school in 1998: If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into the seventh one instead of putting more money into your first one is going to be terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. Why a Hedged Portfolio Because we’re not Warren Buffett. We don’t have vast wealth to absorb large losses, and hedging limits our downside risk in the event that we pick the wrong stocks, or the market moves against us. There is, of course, a tradeoff between what we are willing to risk and our 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 25% decline will have a chance at higher returns than one who is only willing to risk, say, a 15% drawdown. For the purposes of this example, we’ll split the difference and create a hedged portfolio designed for an investor with $100,000 who is willing to risk a drawdown of no more than 20%. Constructing A Hedged Portfolio We’ll summarize process the hedged portfolio process here, and then explain how you can implement it yourself. 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 high potential returns (we define potential return as a high-end, bullish estimate of how the security will perform). 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 portfolios 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 In this case, we’re going to start with the universe of stocks rated by GMI as likely to “substantially outperform the market”. To quantify potential returns for these stocks, you can, for example, use analysts’ price targets for them and then convert these to percentage returns from current prices. 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 potential returns. Our method starts with calculations of six-month potential returns. Finding inexpensive ways to hedge these securities First, you’ll need to determine whether each of these top holdings are hedgeable. Then, whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-20% decline over the time frame covered by your potential return calculations (our method attempts to find optimal static hedges using collars as well as protective puts going out approximately six months). And you’ll need to calculate your cost of hedging as a percentage of position value. Selecting the securities with highest net potential returns In order to determine which securities these are, out of the list above, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you’ll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and exclude any security that has a negative potential return net of hedging costs. Fine-tuning portfolio construction You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs, so if you’re going to include a handful of securities from the sort in the previous step and you have a relatively small portfolio, you’ll need to take into account the share prices of the securities. Another fine-tuning step is to minimize cash that’s leftover after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won’t need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method searches for what we call a “cash substitute”: that’s 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 specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step. 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. In a series of 25,412 backtests over an 11-year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns. An Automated Approach Here we’ll show an example of creating a hedged portfolio starting with 1-rated GMI stocks using the general process described above, facilitated by the automated hedged portfolio construction tool at Portfolio Armor . Narrowing Down Our List of Stocks To get the universe of 1-rated GMI stocks we used Fidelity ‘s screener to screen for optionable stocks rated 1, or “substantially outperform” according to the GMI AGR Equity Risk Rating. Since over 1,000 stocks met those two criteria, we added a third: 52-week price performance in the top 20% by industry. That winnowed the list to 247 names, and we picked the top 5 to input into our automated hedged portfolio construction tool: ABIOMED (NASDAQ: ABMD ) Bassett Furniture Industries (NASDAQ: BSET ) Sketchers USA (NYSE: SKX ) JetBlue Airways (NASDAQ: JBLU ) Universal Insurance Holdings (NYSE: UVE ) Using the Automated Tool In the first step, we enter the five ticker symbols in the “Tickers” field, the dollar amount of our investor’s portfolio (100000) in the field below that, and in the third field, the maximum decline he’s willing to risk in percentage terms (20). In the second step, we are given the option of entering our own potential return estimates for each of these securities. Instead, in this case, we’ll let Portfolio Armor supply its own potential returns. A couple 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 included all of the entered securities for which it calculated a positive potential return, net of hedging costs. In this case, that turned out to be three of the five stocks, ABMD, JBLU, and SKX. Since it aims to include four primary securities in a portfolio of this size, and only three of the ones we entered had positive net potential returns, Portfolio Armor added one of its own top-ranked stocks, Post Holdings (NYSE: POST ). In its fine-tuning step, it added Restoration Hardware (NYSE: RH ) as a cash substitute. Let’s turn our attention now to the portfolio level summary for a moment. 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 their hedges expired, the portfolio would decline 18.78%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -0.26%, meaning the investor would receive more income in total from selling the call legs of the collars on his positions than he spent buying the puts. Best-Case Scenario At the portfolio level, the net potential return is 12.07% over the next six months. This represents the best-case scenario, if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 4.93% represents a conservative estimate, based on the historical relationship between our calculated potential returns and backtested actual returns. By way of comparison, a hedged portfolio created on Friday using the same and decline threshold (20%), but without entering any ticker symbols (i.e., letting Portfolio Armor pick all the securities), had an expected return of 6.1%. You can see that hedged portfolio in a recent article (“Investing While Guarding Against Extensive Vertical Losses”). Each Security Is Hedged Note that each of the above securities is hedged. Restoration Hardware, the cash substitute, is hedged with an optimal collar with its cap set at 1%, and the remaining securities are hedged with optimal collars with their caps set at each underlying security’s potential return. Here is a closer look at the hedge for JetBlue: JetBlue is capped here at 14.25%, because that’s the potential return Portfolio Armor calculated for it over the next several months. As you can see at the bottom of the image above, the cost of the put protection in this collar is $1,050, or 5.7% of position value. But if you look at the image below, you’ll see the income generated from selling the calls is $735, or 3.99% of position value. So, the net cost of this optimal collar is $315, or 1.71% of position value.[i] Note that, although the cost of hedging this position is positive, the cost of hedging the portfolio as a whole is negative. 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 this instablog post on hedging the iPath S&P 500 VIX ST Futures ETN (NYSEARCA: VXX ). [i]To be conservative, this optimal collar shows the puts being purchased at their ask price, and the calls being sold at their bid price. In practice, an investor can often buy the puts for less (i.e., at some point between the bid and ask prices) and sell the calls for more (again, at some point between the bid and ask). So the actual cost of opening this collar would have likely been less. That’s true of the other hedges in this portfolio as well. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.