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An Alternative To Cash For A Risk-Averse Investor

Summary Investors nearing retirement and others wary of current market conditions can use the hedged portfolio method to get a higher return than cash. We explain the method, and present a sample hedged portfolio for an investor unwilling to risk more than a 4% drawdown over the next six months. This sample hedged portfolio has a negative hedging cost and an expected return 20 times that of the average jumbo money market yield. Searching For A Safe Harbor In A Stormy Market After the turbulence of the last week, some investors expected Monday’s calmness to continue on Tuesday, but, as Seeking Alpha news editor Carl Surran reported , that wasn’t the case (“Stock sell-off, turbulence return with a vengeance”): Investors had hoped last week’s volatility had passed after calmer sessions on Friday and Monday, but the turbulence returned today, showing ” we’re not out of the woods by any means ,” said Meridian Equity Partners’ Jonathan Corpina. Surran went on to note that the major indexes all ended the session in correction territory, with the Dow off 12% from its high in May. While corrections can offer opportunities for more aggressive investors, some investors have less tolerance for risk. In this post, we’ll look at an approach that can offer a safe harbor for the next several months for risk-averse investors. Dealing With Uncertainty One way to deal with the uncertainty exemplified by the last several market sessions is to invest in a handful of securities you think will do well, and hedge against the possibility that you end up being wrong. That approach is systematized in the hedged portfolio method, which we detailed in a previous post (“Backtesting The Hedged Portfolio Method”). One advantage of the hedged portfolio method is that it can accommodate a broad range of risk tolerances. If you can tolerate a drawdown of more than 20%, our research (summarized in the previous post we mentioned above) suggests you can achieve returns as good or better than the market over time with less risk. But a similar approach can also be used for investors who can only tolerate smaller drawdowns. Below, we’ll recap how you can build a hedged portfolio yourself (or for a client), and present an example of a hedged portfolio created for an investor with $1,000,000 to invest who can’t tolerate a drawdown of more than 4%. Risk Tolerance, Hedging Cost, 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”) – the higher his expected return will be. In a previous post (“Keeping A Small Nest Egg From Cracking”), we created a hedged portfolio for a small investor who could tolerate a drawdown of as much as 20%. In this case, with an investor who can only tolerate a 4% drawdown, we would expect a lower return. Constructing A Hedged Portfolio 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). Note that when creating a hedged portfolio for an extremely risk-averse investor, such as in this case, the second criteria (“inexpensive to hedge”) will outweigh the first (“high potential returns”) because it may not be possible to hedge the securities with the highest potential returns against such small declines. 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 securities with positive potential returns For this, you can use Seeking Alpha Pro , among other sources. Seeking Alpha articles often include price targets for long ideas, and you can convert these to percentage returns from current prices. But you’ll need to use the same time frame for each of your expected return calculations to facilitate comparisons of expected returns, hedging costs, and net expected returns. Our method starts with calculations of six-month potential returns. Finding Securities That Are Relatively Inexpensive To Hedge For this step, you’ll need to find hedges for the securities with positive potential returns, and then calculate the hedging cost as a percentage of position value for each security. Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-4% 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. Buying Securities That Score Well On The First Two Criteria To determine which securities these are, 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 sort the securities by their potential returns net of hedging costs, or net potential returns. The securities that come to the top of that sort are the ones you’ll want to consider for your portfolio. Fine-Tuning Portfolio Construction You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs. 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 An Expected Return 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. Example Of A Hedged Portfolio Here is an example of a hedged portfolio created using the general process described above by the automated portfolio construction tool at Portfolio Armor . With that tool, you just enter the dollar amount you are looking to invest and the largest drawdown you are willing to risk (your “threshold” – in this case, 4%), and the tool does the rest. This portfolio was generated as of Monday’s close (results will vary at different times, depending on market conditions), and used as its inputs the parameters we mentioned for our hypothetical investor above: $1,000,000 to invest, and a goal of maximizing potential return while limiting downside risk, in the worst-case scenario, to a drawdown of no more than 4%. 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 the hedges expired, the portfolio would decline 3.97%. Negative Hedging Cost Note that, in this case, the total hedging cost for the portfolio was negative, -1%, 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 3.55% (as predicted, it’s less than the potential return for the 20% threshold portfolio we alluded to above, which was 17.79%). 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 1.23% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns. A Better Return Than Cash According to the FDIC , the national average rate for jumbo money market accounts as of August 31 was 0.12%, which equates to a 0.06% rate over 6 months. The 1.23% expected return of the hedged portfolio above is 20.5x as high. Of course, your maximum drawdown on the money market is 0%, which is not the case with the hedged portfolio. Each Security Is Hedged Note that in the portfolio above, each of the three underlying securities – Google (NASDAQ: GOOG ) (NASDAQ: GOOGL ), Intuitive Surgical (NASDAQ: ISRG ), and Precision Castparts (NYSE: PCP ) is hedged (Google appears twice in the portfolio, once as a primary security, hedged with an optimal collar capped at its potential return, and once hedged as a cash substitute, with its cap set at 1%. Because of the different way these positions are hedged, they have different expected returns). Hedging each security according to the investor’s risk tolerance obviates the need for broad diversification, and lets him concentrate his assets in a handful of securities with positive potential returns net of their hedging costs. Here’s a closer look at the hedge for one of these positions, ISRG: As you can see in first part of the image above, ISRG is hedged with an optimal collar with its cap set at 4.95%, which was the potential return Portfolio Armor calculated for the stock: the idea is to capture the potential return while offsetting the cost of hedging by selling other investors the right to buy ISRG if it appreciates beyond that over the next six months.[i] The cost of the put leg of this collar was $7,800, or 7.75% of position value, but, as you can see in the image below, the income from the short call leg was $6,660, or 6.61% as percentage of position value. Since the income from the call leg offset some of the cost of the put leg, the net cost of the optimal collar on ISRG was $1,140, or 1.13% of position value.[ii] Note that, although the cost of the hedge on this position was positive, the hedging cost of this portfolio as a whole was negative . Why These Particular Securities? Ordinarily, Portfolio Armor aims to include seven primary securities and one cash substitute for a $1 million portfolio, but very few securities can be cost effectively hedged against a drawdown of no more than 4%. Google, Intuitive Surgical, and Precision Castparts were exceptions on Monday. Of the three, readers might be most surprised to see Precision Castparts included, given the announcement last month that Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ) would acquire the company for $235 per share. Usually, Portfolio Armor won’t include a security after an announcement that it is going to be acquired, because option market sentiment indicates that there’s no chance of any significant further appreciation for the stock to be acquired. In this case, on Monday, option market sentiment indicated there was a chance for a small amount of further appreciation beyond the 2.35% the stock would rise if the Berkshire deal closes at $235. That said, Seeking Alpha contributor Lukas Neely estimates that there’s a 95% chance the Berkshire deal closes (“Is Warren Buffett’s Precision Castparts Deal A Merger-Arb Opportunity”), in which case, the actual return for this position, net of hedging costs, would be 0.35%, rather than the 1.25% our algorithm expects. 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 recent instablog post on hedging Tesla (NASDAQ: TSLA ). Hedged Portfolios For Even More Risk-Averse Investors The hedged portfolio shown above was designed for a small investor who could tolerate a decline of as much as 4% over the next six months, but the same process can be used for investors who are even more risk-averse, willing to risk drawdowns of as little as 2%. Notes: [i] This hedge actually expires in a little more than 7 months, but the expected returns are based on the assumption that an investor will hold his positions for six months, until they are called away or until shortly before their hedges expire, whichever comes first. [ii] To be conservative, the net cost of the collar was calculated using the bid price of the calls and the ask price of the puts. In practice, an investor can often sell the calls for a higher price (some price between the bid and ask) and he can often buy the puts for less than the ask price (again, at some price between the bid and ask). So, in practice, the cost of this collar would likely have been lower. 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.

TerraForm Power: Is It Time To Buy This YieldCo?

Considering the recent downfall in TerraForm Power stock levels we look at if it is worth investing in this security. We review various risk factors and our assessment on required yield based on the risk factors. Currently we view the valuation range of $17.50 to $20 subject to downward revision if Vivint Acquisition goes through. Over the last year, we have been consistently negative on YieldCo valuations and did not see a reason to invest in any of the YieldCos in the market. We were of the opinion that the market was mispricing risk in the long term assets held by these YieldCos. However, the yield bubble that we were in for much of the last year has caused many of the YieldCos to be priced at incredibly high valuations and consequently drove project developers like SunEdison (NYSE: SUNE ) go on an unsustainable growth path. One of the risks of this yield mispricing is that project developers counting on low yields tend to develop projects at unacceptably low margins. When yields rise, as they did recently, these developers find themselves cash strapped and with limited options on exiting from the projects under development. That is the quagmire that SunEdison finds itself in today. Companies affected by this same malady but to a much lesser extent, in an approximate order of declining risk, include SolarCity (NASDAQ: SCTY ), Vivint Solar (NYSE: VSLR ), SunRun (NASDAQ: RUN ) in the residential sector and Canadian Solar (NASDAQ: CSIQ ), SunPower (NASDAQ: SPWR ), Fist Solar (NASDAQ: FSLR ), Trina Solar (NYSE: TSL ) and JinkoSolar (NYSE: JKS ) in the large scale project sector. Of the above group, we are skeptical about the survival chances of the residential solar installers as their risks are far in excess of what the markets currently comprehend. Of the latter group, we believe the risk factors are more manageable given the manufacturing component of the companies, the much smaller project component, cost/margin advantage due to the use of in-house panels, and the location and returns of the assets under development. Of the solar asset holding companies, only SunEdison, First Solar and SunPower have their own YieldCos. When it comes to these companies many investors have tended to tie the performance of these sponsor companies with their YieldCos. As misguided as that line of thinking was, the markets and the Wall Street analyst community played a role in reinforcing that sentiment. However, we believe the time has now come to decisively cut the cord between sponsors and YieldCos and look at these companies separately and objectively. With this mindset, we now review the prospects for TerraForm Power (NASDAQ: TERP ). It should be noted that TerraForm Power has fallen from a peak of about $42 in April of this year to about $22 today – almost a 50% correction for a so called stable yield vehicle. At the current price, TerraForm Power yields about 6% on a TTM dividend basis and about 8% on forecasted 2016 dividend basis. Is the current stock price a reasonable approximation of the Company value? Or, conversely, is the yield level appropriate for this class of assets? To evaluate this, we believe one has to consider the risk factors of the asset base of the YieldCo and assess an appropriate risk/yield level. Our view of the required yields and risk factors are as follows: – To begin with, when it comes to energy assets, investors should note that not all solar asset classes have the same risk. We are of the opinion that, all else being equal, US utility assets deserve a discount rate of about 8%, US high grade commercial assets about 10%, and US residential assets about 12%+. – While TerraForm Power management prides in saying the YieldCo consists mainly of OECD assets and thus low risk, we believe investors should keep close tabs on the source of the assets. Not all OECD countries have similar currency and country risk profiles and some countries have a vastly higher set of risks than others. Several of the currencies have depreciated significantly vis-à-vis dollar and there is not much of a compelling story on why the trends should reverse. In general, assets from any country with likely future depreciation against dollar should cause the yield to increase. – Remaining life of the PPA is also a significant risk factor. With the rapidity of the changes in the solar industry, it is likely that some of the solar PPAs will not even be renewed. To the extant they are renewed, it is likely that they will be renewed at prices far lower than the existing PPA levels. – It is also likely that many of the assets would require significant upgrades for them to be renewed. For example, the utility or commercial customer may demand certain amount of dispatchability or a shaping of the energy. The capital costs required at renewal for any such changes and upgrades should be rolled into the IRR and yield calculations. – The rate of the PPA compared to the current market should also be a consideration. The larger the disparity between market and PPA rates, the higher the motivation for the customer to renegotiate and a chance that the asset may become distressed. – The potential for curtailment for each of the assets should be evaluated and discounted. – Wind resources, on the other hand, have a different risk profile than solar. Wind has an energy profile that complements the solar production and may end up holding up better in terms of PPA prices in the future. Wind resources may also likely need smaller battery support to make the power plant resources “pseudo dispatchable”. In other words, the wind assets may have a lower risk factor at renewal time than solar assets. – Investors should note that this is only a partial list of risks and any other risks specific to an asset or asset class should also be considered and impact evaluated While having a checklist can be useful, there are multiple challenges in evaluating the risks and costs we present above starting with disclosures. Even if the risks and costs can be reasonably identified, weighing of the factors is, at best, an informed estimate. When dealing with such unknowns, a reasonable safety margin is mandatory. Without using much scientific rigor in analysis, our estimate is that the current portfolio of assets in TerraForm Power need to yield at least 10% to provide a satisfactory risk adjusted return to investors. This, in turn, would imply that the valuation of TERP is likely around $17.50 a share based on forward guidance. Note that this valuation does not give any premium for growth. One question to ponder in this context is how much growth is possible at the new and increased cost of equity. To understand the Company’s growth potential, one has to estimate the future cost of capital for TerraForm Power. Firstly, while it is true that the cost of equity has gone up substantially for TERP, we believe that there is a reasonable chance that TerraForm Power can obtain debt capital at attractive rates. Secondly, markets have consistently demonstrated that unsophisticated investors are likely to buy debt and equity at surprisingly high valuations. If TerraForm Power can attain a WACC in the 8 to 10% range, we believe that growth, though hard to come by, is possible. Discounting for possible growth, and assuming a fairly benign yield environment, we can see TerraForm Power’s intrinsic value reaching about $20 by the end of 2016. This, of course, assumes that asset quality remains reasonable. As we wrap up this discussion, investors should consider another key factor when acquiring a YieldCo stock. While the current yield bubble has burst, it is neither the first one not will it be the last one. With Wall Street’s penchant for newfangled metrics, and with no shortage of investors subscribing to yet another non-standard valuation methodology, managements will always be faced with bubbles in the stock price and yields and will be issuing new equity or debt to take advantage of it. When the prices of these instruments correct from bubble levels, the preexisting stockholders who acquired the equity at a lower level will be beneficiaries of the largesse of the new stockholders. To benefit from this effect, it is very important for yield oriented investors to accumulate the YieldCo stock when the asset class is out of favor and shun purchases when the asset class is trading at rich valuation levels. All things considered, for yield oriented investors, we see TerraForm Power as a buy in the $17.50 to $20 range. While the stock has not gotten to this trading range, alert investors may be able to enter the position when there is a market weakness. Alternately, given the limited downside from the stated levels, the position can also be entered through selling puts at the $17.50 or $20 levels. The key risk factor at this point for this YieldCo is the acquisition of Vivint Solar . While this deal makes increasingly less sense, management has continued to stick with it to date. Vivint asset purchase and the aggressive addition of residential assets ahead of ITC step down could push up the risk adjusted yield requirements of the portfolio to north of 11%. In such an event, the entry point to TerraForm Power should be adjusted accordingly. Given the emerging nature of the energy landscape, we believe there may be several unanticipated risk factors for this equity and from that view, TerraForm Power can be considered overvalued. Summary Of Our View: Enter through selling put contracts in the $17.50 to $20 range. Disclosure: I am/we are long FSLR, SUNE, JKS, TSL, CSIQ. (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.

Ivy Portfolio September Update

The Ivy Portfolio spreadsheet tracks the 10-month moving average signals for two portfolios listed in Mebane Faber’s book The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets . Faber discusses 5, 10, and 20 security portfolios that have trading signals based on long-term moving averages. The Ivy Portfolio spreadsheet tracks both the 5 and 10 ETF Portfolios listed in Faber’s book. When a security is trading below its 10-month simple moving average, the position is listed as “Cash.” When the security is trading above its 10-month simple moving average, the position is listed as “Invested.” The spreadsheet’s signals update once daily (typically in the late evening) using dividend/split adjusted closing price from Yahoo Finance. The 10-month simple moving average is based on the most recent 10 months including the current month’s most recent daily closing price. Even though the signals update daily, it is not an endorsement to check signals daily or trade based on daily updates. It simply gives the spreadsheet more versatility for users to check at his or her leisure. The page also displays the percentage each ETF within the Ivy 10 and Ivy 5 Portfolio is above or below the current 10-month simple moving average, using both adjusted and unadjusted data. If an ETF has paid a dividend or split within the past 10 months, then when comparing the adjusted/unadjusted data you will see differences in the percent an ETF is above/below the 10-month SMA. This could also potentially impact whether an ETF is above or below its 10-month SMA. Regardless of whether you prefer the adjusted or unadjusted data, it is important to remain consistent in your approach. My preference is to use adjusted data when evaluating signals. The current signals based on August 31st’s adjusted closing prices are below. It will probably come as no surprise that this month all ETFs; the Vanguard Total Bond Market ETF (NYSEARCA: BND ), the SPDR Dow Jones International Real Estate ETF (NYSEARCA: RWX ), the Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ), the PowerShares DB Commodity Index Tracking ETF (NYSEARCA: DBC ), the iShares S&P GSCI Commodity-Indexed Trust ETF (NYSEARCA: GSG ), the Vanguard REIT Index ETF (NYSEARCA: VNQ ), Vanguard Total Stock Market ETF (NYSEARCA: VTI ), Vanguard Small Cap ETF (NYSEARCA: VB ), Vanguard FTSE All-World ex-US ETF (NYSEARCA: VEU ), and the iShares TIPS Bond ETF (NYSEARCA: TIP ), are below their 10-month moving average. Last month 7 of the 10 were below their respective moving average. The spreadsheet also provides quarterly, half year, and yearly return data courtesy of Finviz. The return data is useful for those interested in overlaying a momentum strategy with the 10-month SMA strategy: (click to enlarge) (click to enlarge) I also provide a “Commission-Free” Ivy Portfolio spreadsheet as an added bonus. This document tracks the 10-month moving averages for four different portfolios designed for TD Ameritrade, Fidelity, Charles Schwab, and Vanguard commission-free ETF offers. Not all ETFs in each portfolio are commission free, as each broker limits the selection of commission-free ETFs and viable ETFs may not exist in each asset class. Other restrictions and limitations may apply depending on each broker. Below are the 10-month moving average signals (using adjusted price data) for the commission-free portfolios: (click to enlarge) (click to enlarge) Disclosures: None.