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Summary An investor can “bulletproof” his portfolio while maximizing his expected return using the hedged portfolio method. When creating a hedged portfolio, you can start from scratch or start by narrowing down your universe of stocks. We explore the second method here. The stock we start with are ones with lower betas. Although CAPM predicts lower beta stocks will have lower returns, evidence suggests the opposite is the case. Since lower beta stocks are not without risk, owning them within a hedged portfolio can make sense. We recap the hedged portfolio method, show how you can build a hedged portfolio of lower beta stocks yourself, and provide a sample portfolio. Seeking Beta The traditional view of lower beta stocks, encapsulated in the Capital Asset Pricing Model ( CAPM ), is that they offer lower risk than higher beta stocks, but also lower returns. Seeking Alpha contributor and hedge fund manager Dr. Eric Falkenstein is one of the researchers who has challenged that, presenting evidence that lower beta stocks actually generate higher returns than higher beta stocks. In a 2012 Seeking Alpha article (“Is Low Vol A Beta Phenomenon”), Falkestein included the chart below, showing that, among the top 1500 stocks by market cap (excluding financials), stocks with lower beta (average beta of 0.85 versus 1 for the market) had outperformed both the market and high beta stocks since 1990. The Risks of Investing in Lower Beta Stocks As with any style of stock investing, when investing in lower beta stocks, you face two kinds of risks: idiosyncratic risk , the risk of something bad happening to one of the companies you own, and market risk , the risk of your investments suffering due to a decline of the market as a whole. By definition, the market risk of lower beta stocks should be less than that of the market (assuming the lower beta stocks you buy remain lower beta, which isn’t always the case, as Seeking Alpha contributor Matti Suominen has noted ), but the idiosyncratic, or stock-specific risk of lower beta stocks may come as a surprise to some investors. Six months ago, for example, how many investors in Wal-Mart (NYSE: WMT ) (beta: 0.82) would have thought they would be down nearly 25% on the stock by mid-October, as the chart below shows? (click to enlarge) Two Ways of Limiting Stock-Specific Risk One way to limit stock-specific risk is via hedging; another way is via diversification. In a previous article (“How to Limit Your Market Risk”), we discussed ways to limit market risk for a diversified portfolio. In this post, we’ll look at how to “bulletproof” a concentrated portfolio of lower beta stocks using the hedged portfolio method . In that method, you limit both stock-specific and market risk via hedging. Below, we’ll show how to use that method to construct a “bulletproof”, or hedged portfolio for an investor who is unwilling to risk a drawdown of more than 16%, and has $250,000 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 6% drawdown. In our example, we’ll be splitting the difference and using a 16% threshold. Constructing A Hedged Portfolio We’ll outline the process here briefly, 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 promising 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 lower beta stocks Most brokerage websites offer screeners that let you screen for lower beta stocks. Since you’re going to hedge your stocks, you’ll want to limit your screen to stocks that are optionable. Next, you’ll need to calculate potential returns for your lower-beta, optionable stocks. One way to do that is to look up the consensus price targets for each stock, and derive potential returns in percentage terms from them. We offered an example of doing that for Novo Nordisk (NYSE: NVO ) in a recent article (“Building A Hedged Portfolio Around A Position In Novo Nordisk”). 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 Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-16% 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. 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, 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 7% declines, they all had positive net potential returns when hedged against > 16% declines. Nevertheless, the site rejected GOOGL. Why? Because of its share price ($695.32) relative to the size of the portfolio ($250k). For a portfolio of this size, the site attempts to allocate equal dollar amounts to 4 primary securities. Since a quarter of the portfolio would be $62,500, and a round lot of GOOGL would have cost more than that ($69,532), the site eliminated GOOGL from consideration for this portfolio. As it allocated cash to each of the stocks we entered, it rounded down the dollar amounts to get round lots of each stock. In its fine-tuning step, Portfolio Armor added Tesla Motors (NASDAQ: TSLA ) as a cash substitute, to replace most of the cash leftover from the rounding down process. TSLA happens to be a higher beta stock, but the site doesn’t take beta into account when adding cash substitutes; instead, it looks at which securities (whether stocks or exchange traded products) have the highest net potential returns when hedged as a cash substitute. 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 their hedges expired, the portfolio would decline 14.33%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -0.19%, 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 13.77% over the next six months. This represents the best-case scenario, if each underlying security in the portfolio meets its potential return (since three of these positions are uncapped, it’s theoretically possible that the portfolio could return more than 13.77% if each of the uncapped stocks exceeds its potential return). A More Likely Scenario The portfolio level expected return of 5.52% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns. By way of comparison, the average 6 month return for the SPDR S&P 500 ETF (NYSEARCA: SPY ) over the last 10 years was 3.84%. Each Security Is Hedged Note that each of the above securities is hedged. TSLA, the cash substitute, is hedged with an optimal collar with its cap set at 1%, HRL is hedged with an optimal collar, with its cap set at its potential return, and the other 3 primary securities are hedged with optimal puts, which are uncapped. 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 unless their net potential returns, when hedged with collars, are > 1.93x higher. That was the case with HRL, which is why it’s hedged with an optimal collar. That wasn’t the case for the other three primary securities, which is why they’re hedged with optimal puts. Here’s a closer look at the optimal put hedge on MO: The cap field above is blank, as this is an optimal put, which is uncapped. As you can at the bottom of the image above, the cost of the put protection on MO was $840, or 2.04% as a percentage of position value.[i] Note that, although the cost of this hedge was positive, the overall cost of hedging the portfolio was 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 Tesla. [i] To be conservative, Portfolio Armor calculated the hedging cost using the ask price of the puts; in practice an investor can often buy puts for less (for some price between the bid and the ask). 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 (i.e., an investor would have collected more than $465, on net, after opening the hedges).