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Building A Bulletproof Portfolio Of Lower Beta Stocks

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).

Hit Or Miss – Do ‘Target Date’ Funds Introduce More Investment Risks Than They Counter?

By Kevin Murphy Building in a margin of safety may be an integral part of value investing – as we noted most recently in Eyes front – but one also sees plenty of instances of it in everyday life. Most people, for example, prefer to turn up to a station a few minutes early rather than risk missing their train and most people will buy a few extra bottles for a party rather than risk seeing their guests go thirsty And almost everyone, we imagine, would be happy to admire a clifftop view from a few feet back rather than stand on the very edge and risk a long drop down. What then should we make of a type of investment fund that arguably not only verges upon this sort of brinkmanship but towards which U.K. consumers are now being encouraged to direct their money? ‘Target date’ funds, also known as ‘lifestyle funds, are portfolios whose asset mix grows progressively more conservative – essentially moving more towards bonds and cash – as the target date approaches. According to BrightScope, more than $1.1 trillion (£724bn) is now invested in these funds – a 280% increase in just five years – and the research firm predicts that figure will top $2 trillion by 2020. A significant factor in this growth was the introduction in the US of the 2006 Pension Protection Act, which obliges employers to identify a default option for staff who do not choose a specific fund for their pension contributions. Target date funds were deemed suitable candidates for this because of their evolving asset mix and the introduction of auto-enrolment in the U.K. has led to a similar trend here. Target date theory A target date fund – so the theory goes – offers greater exposure to equities for a younger investor, who may be expected to have a higher tolerance for risk. As an investor grow older, the equity allocation is scaled back in favor of increasing levels of bonds and cash so that, at the target date (usually the point of retirement), the portfolio – so the theory goes on – is effectively ‘de-risked’. But is it really? Investment risk can take many forms and, by paring back equities in favor of bonds and cash as retirement approaches, a target date fund may indeed reduce some risks for some investors. Yet we would argue this sort of fund also serves, perversely, to increase some risks for some investors – and certainly enough to raise some question marks over the vehicle’s current ‘default’ status. The principal risks that target date funds aim to address are volatility and date risk. A less volatile portfolio that offers an increasing level of, if not certainty, then at least reassurance about the eventual size of a pension pot can undeniably be helpful to certain types of investor – most obviously those planning to use that pot to buy an annuity. Anyone in that position would naturally wish to protect the pot they have built up over decades from the risk of, say, a 30% fall in equities in the months before they plan to cash it in. The problem is, now U.K. law has changed and people are no longer obliged to buy an annuity on retirement, a target date fund that moves from equities into bonds and cash is arguably not de-risking so much as ‘up-risking’. New risk considerations To our minds, target date funds bring into play two risk considerations in particular – longevity risk and inflation risk. We could discuss the first point – how long we might reasonably expect to live – in a number of ways but will restrict ourselves to just a couple. One relates to averages, the other to probability. Both bolster the case for building a margin of safety into your retirement planning. It is widely accepted that life expectancy is, on average, increasing. It is hardly prudent financial planning, however, to base the length of time you will need your pension pot to last on an average. By definition, a significant number of people live longer than average and it make sense to work on the basis that you could well be one of them. To frame this point in a different way, the following table aims to give an indication of just how people can live longer than average. It shows the percentage chances of someone in the U.K. making it to their 100th birthday, depending on their age today. So a 65-year-old man now has a roughly one-in-12 chance of living to 100 while, for a 65-year-old woman, it is closer to a one-in-eight chance. Males Females Total Age in 2011 Population in 2011(‘000s) Chance of reaching age 100 Number to reach age 100 (‘000s) Population in 2011 (‘000s) Chance of reaching age 100 Number to reach age 100 (‘000s) Number to reach age 100 (‘000s) 0 397 25.7% 102 378 33.4% 126 228 1 398 25.5% 101 379 33.1% 126 227 2 401 25.1% 101 383 32.8% 125 226 3 404 24.8% 100 386 32.4% 125 225 4 388 24.4% 95 370 32.1% 119 213 5 375 24.1% 90 359 31.7% 114 204 6 367 23.8% 87 351 31.3% 110 197 7 362 23.4% 85 345 31.0% 107 192 8 350 23.1% 81 333 30.6% 102 183 9 340 22.7% 77 325 30.2% 98 176 10 340 22.4% 76 326 29.9% 97 174 11 350 22.1% 77 332 29.5% 98 175 12 359 21.7% 78 343 29.1% 100 178 13 365 21.4% 78 349 28.8% 101 179 14 377 21.1% 79 358 28.4% 102 181 15 375 20.7% 78 356 28.1% 100 178 16 379 20.4% 77 359 27.7% 99 177 17 390 20.1% 78 370 27.3% 101 179 18 401 19.8% 79 381 27.0% 103 182 19 421 19.4% 82 401 26.6% 107 189 20 436 19.1% 83 412 26.3% 108 192 21 436 18.8% 82 415 25.9% 108 190 22 442 18.5% 82 426 25.6% 109 191 23 457 18.2% 83 439 25.2% 111 194 24 458 17.9% 82 438 24.9% 109 191 25 459 17.6% 81 446 24.5% 109 190 26 468 17.3% 81 447 24.2% 108 189 27 457 17.0% 78 431 23.9% 103 181 28 442 16.7% 74 414 23.5% 97 171 29 423 16.4% 69 411 23.2% 95 165 30 430 16.1% 69 417 22.8% 95 165 31 425 15.8% 67 414 22.5% 93 161 32 401 15.6% 62 397 22.2% 88 150 33 379 15.3% 58 379 21.9% 83 141 34 373 15.0% 56 372 21.5% 80 136 35 383 14.8% 57 382 21.2% 81 137 36 392 14.5% 57 392 20.9% 82 139 37 400 14.2% 57 402 20.6% 83 140 38 417 14.0% 58 422 20.3% 86 144 39 435 13.7% 60 446 19.9% 89 149 40 448 13.5% 60 457 19.6% 90 150 41 446 13.2% 59 451 19.3% 87 146 42 455 13.0% 59 464 19.0% 88 147 43 460 12.7% 58 465 18.7% 87 145 44 469 12.5% 58 475 18.4% 87 146 45 463 12.2% 57 476 18.1% 86 143 46 464 12.0% 56 478 17.8% 85 141 47 457 11.8% 54 474 17.5% 83 137 48 448 11.5% 52 467 17.3% 81 132 49 437 11.3% 49 453 17.0% 77 126 50 427 11.1% 47 441 16.7% 74 121 51 410 10.9% 45 423 16.4% 69 114 52 402 10.7% 43 413 16.2% 67 110 53 396 10.5% 41 405 15.9% 64 106 54 380 10.3% 39 390 15.7% 61 100 55 365 10.1% 37 376 15.4% 58 95 56 355 9.9% 35 365 15.2% 55 91 57 354 9.7% 35 365 14.9% 55 89 58 347 9.6% 33 358 14.7% 53 86 59 342 9.4% 32 356 14.5% 51 84 60 341 9.2% 32 358 14.2% 51 82 61 348 9.1% 32 367 14.0% 51 83 62 357 8.9% 32 376 13.8% 52 84 63 381 8.8% 33 402 13.6% 54 88 64 397 8.6% 34 420 13.4% 56 90 65 319 8.5% 27 340 13.2% 45 72 66 308 8.4% 26 330 13.0% 43 68 67 300 8.3% 25 320 12.8% 41 66 68 284 8.2% 23 308 12.6% 39 62 69 254 8.1% 20 277 12.5% 35 55 70 235 8.0% 19 259 12.3% 32 51 71 241 7.9% 19 268 12.2% 33 52 72 236 7.8% 18 266 12.0% 32 50 73 229 7.6% 17 260 11.7% 30 48 74 218 7.5% 16 251 11.4% 29 45 75 206 7.3% 15 242 11.1% 27 42 76 194 7.0% 14 231 10.7% 25 38 77 178 6.8% 12 219 10.3% 22 35 78 170 6.6% 11 213 9.8% 21 32 79 162 6.3% 10 208 9.4% 20 30 80 152 6.1% 9 203 9.0% 18 28 81 138 5.9% 8 192 8.7% 17 25 82 124 5.8% 7 179 8.5% 15 22 83 110 5.8% 6 164 8.4% 14 20 84 100 5.9% 6 155 8.4% 13 19 85 89 6.0% 5 145 8.5% 12 18 86 77 6.2% 5 132 8.7% 11 16 87 66 6.5% 4 120 8.9% 11 15 88 56 6.9% 4 108 9.3% 10 14 89 49 7.4% 4 99 9.8% 10 13 90 42 8.1% 3 91 10.4% 9 13 91 32 9.0% 3 73 11.3% 8 11 92 22 10.2% 2 51 12.6% 6 9 93 14 11.9% 2 36 14.5% 5 7 94 11 14.4% 2 29 17.2% 5 6 95 8 18.2% 1 23 21.1% 5 6 96 6 23.8% 1 18 27.0% 5 6 97 4 32.3% 1 13 35.8% 5 6 98 2 45.5% 1 9 49.0% 5 6 99 2 66.3% 1 6 68.9% 4 5 Source: Department for Work and Pensions, April 2011 In terms of significance of impact, we are closer here to a clifftop fall than a missed train. When it comes to planning a comfortable retirement, of course you build in a margin of safety – and that means considering the outliers. Today, 35-year-old men and women have, respectively, a one-in-seven and a one-in-five chance of reaching 100. Prudent financial planning As we illustrated in Mean well , averages are not as simple as one might imagine. In the context of ‘average’ life expectancy, we would all do well to think in terms of the ‘median’ or ‘mode’ rather than the necessarily shorter ‘arithmetic mean’. Simply put, to lessen the chances of your money running out, it would seem prudent to factor the possibility of a ripe old age into your financial planning. A second important point is that you do not want to plan your retirement in such a way that you reach 65 with the prospect of living decades longer while holding a pension pot that has actively worked to minimize almost all hope of growing your money over that time. This, of course, leads to our other major concern about target date funds – inflation risk. ‘De-risking’ a portfolio by moving into bonds and cash may have become the perceived wisdom in some circles on both sides of the Atlantic, but it totally ignores the potential impact of inflation. Sitting for any significant amount of time in assets – including bonds and, especially, cash – that offer little or no protection against inflation is, frankly, not responsible financial planning. Say you need an annual income of £10,000 in retirement and inflation holds steady at 3% – if your assets see no growth then, were you to make it to 100, inflation would have effectively eroded that £10,000 down to some £3,500. So how do you go about protecting your retirement income from the risk of inflation? If you want to retain your purchasing power over the coming years, and possibly decades, you will need your pension pot to increase, on average, at least by the rate of inflation. A growing income Since temporary fluctuations in the size of their pension pot are likely to be of less concern to most people than seeing their income steadily eroded by the effects of inflation, a portfolio of equities that is prudently managed with a view to generating a growing income over time has to be a consideration for a section of the population that has particular reason to be worried about longevity and inflation. Here on The Value Perspective, we can see why target date funds have been held out in recent years as a solid default option for – and consequently embraced by – employers and pension schemes. Do not forget, however, that any duty of care they owe you stops the day you retire – at which point, unless you are in a position to obtain financial advice, you are pretty much on your own. A real income strategy is, we believe, better able to offer more people a greater margin of safety – and thus comfort – as they save for and then live through their retirement than the target date funds that, in some quarters, are now held out as the way ahead for employers and pension schemes. Standing at the top of a cliff is not the only time you need to be wary about any sort of ‘great leap forward’.

What Smart Beta Can’t Do

The growth of assets in Smart Beta ETFs is staggering. From Michael Batnick : Investors have become enamored with alternative ways to slice and dice the indices. According to Morningstar , “Strategic Beta” now accounts for 21% of total industry (ETP) assets, up from under 5% in 2000. As assets have exploded, so too has the number of strategic-beta ETPs, which have grown from 673 to 844 in the past year, while assets grew 25% to $497 billion. While much of the focus is on the nomenclature- “smart” vs. “factor” vs. “strategic,” perhaps the most important aspect is being overlooked; like all things investing, the product won’t to be drive returns as much as your behavior will. To demonstrate this point, I chose five popular strategies that differ from the traditional plain vanilla cap-weighted index: Nasdaq US Buyback Achievers Index, S&P 500 Equal Weight Index, Nasdaq US Buyback Achievers, MSCI USA Momentum Index and the S&P 500 Low Volatility index.* Every one of these Smart Beta strategies has outperformed the S&P 500 from 2007-today**. The problem investors run into, as you can see below, is that very often the best performing in each year lagged the S&P 500 in the prior year. Myopia is a huge impediment to successful investing as much of our “discipline” is driven by “what have you done for me lately?” Each of these five strategies has outperformed the S&P 500 over the previous eight years. Had you chased the prior year’s best strategy, you would have compounded your money at just 3.5%, less than the 6% you would have earned if you invested in the prior year’s worst strategy. This goes to show that mean reversion is a powerful force for a proven, repeatable process. Interesting. There are all kinds of studies showing that when it comes to individual stocks, buying last year’s winners works great (click here for just one of the white papers written on this topic). However, Batnick is arguing that buying last year’s winning Smart Beta ETF is not effective (at least in this short sample) when it comes to investment factors. This has important implications for building an asset allocation that includes a variety of Smart Beta factors: You may well be better off simply seeking to identify those factors that are likely to outperform over time (we like momentum and value in particular) and make passive allocations to those factors rather than trying to time your exposure to them. Smart Beta has, in our view, been a tremendous positive for investors. However, it won’t keep performance-chasing investors from hurting themselves if they fail to allocate money to them in a prudent way. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss. Share this article with a colleague