Boosting Potential Returns

The Trouble with Typical Investment Portfolios

Typical investment portfolios diversify broadly, often via multiple index ETFs. There are two problems with this sort of over-diversification. The first is that it doesn't protect against systemic, or market risk. When the market crashes, as it did in 2008, nearly all stocks plummet, and most other asset classes decline as well (as gold did, for example).

The second problem is that high diversification dilutes potential returns. Instead of having your money concentrated in a handful of investments with the highest expected returns, you have it diluted among many investments with mediocre prospects.

The Portfolio Armor Difference

Since each security is hedged, your potential downside is strictly and precisely limited, without the need for broad diversification or asset allocation. This means you can concentrate your assets in a handful of hedged securities with the highest expected returns.

How It Works

Just enter the dollar value you are looking to invest, and the maximum drawdown you are willing to risk over the next six months (your "threshold")1. Portfolio Armor will present you with an optimally hedged and allocated portfolio with the highest expected return, given your risk tolerance.2

The Portfolio Armor Process

Calculating Potential Returns

Every trading day, Portfolio Armor generates high-end estimates of how more than 3,000 stocks and exchange traded products will perform over approximately the next six months. These estimates are based on analysis of historical returns as well as option market sentiment, which provides a forward-looking element. We call this high-end estimate a security’s potential return. Essentially, it's how the security might perform over the next six months in a bullish scenario. We backtested this method of security selection by running our analysis every trading day over an eleven year period and then looking at the actual returns of the securities with the highest potential returns on our daily scans over the next six months. Over that 11-year period, we conducted 25,412 comparisons of our calculated potential returns to actual returns, an average of 9.4 top-ranked securities each trading day. The average potential return we calculated was 22.4%. The average actual return over the next six months, unhedged, was 6.84%. Since the average actual return was 0.3x the average potential return, we use that 0.3x multiple to derive expected returns from our potential returns. While a potential return represents a bullish upside, an expected return is the more likely result.

A subset of our top-ranked securities – 5,202 of them, or about 20% of them - had an even higher average actual return: 9.35%. All of our top-ranked securities were hedgeable with optimal collars, but the securities in this subset were also hedgeable with optimal puts (we call these AHP securities, for short). There aren’t always AHP securities available, but when there are, our portfolio construction algorithm gives preference to them proportional to their higher average returns in our tests.

The security returns mentioned above were unhedged; we also tested gross returns (i.e., not net of hedging costs) of our security selection method while hedging against greater-than-9% declines. When doing so with optimal puts, the average gross return was 12.08% over six months. The average gross return for the same securities when hedged with optimal collars capped at their potential returns was about half as much, 6.25%. This illustrates to what extent the average actual returns of the securities hedged with optimal puts were driven by outliers – securities that appreciated beyond our calculated potential returns. We adjust for the impact of potential outliers, and the difference in potential returns, during the portfolio construction process.

Scanning For Optimal Hedges

Next, Portfolio Armor uses its proprietary hedging algorithm to scan for an optimal collar hedge for each security, using the maximum drawdown you are willing to risk as the decline threshold, and each security’s potential return as the upside cap. The idea here is to capture each security’s potential return while minimizing your downside risk. At the same time, Portfolio Armor scans for uncapped optimal put hedges for each security (as we noted earlier, only about 20% of securities with the highest potential returns are also hedgeable with optimal puts when using a 9% decline threshold; the percentage increases if you use a higher decline threshold). In each case, where the security is hedged with an optimal collar and where it's hedged with an optimal put, we subtract the hedging cost from the security’s potential return to find the net potential return.

Portfolio Construction

Because the average actual returns of securities hedged with puts were 1.93 times higher than the actual returns of those hedged with collars in our tests, we assume that securities hedged with optimal puts will have a similarly higher net potential return than those hedged with optimal collars. If securities hedged both ways are available, Portfolio Armor will populate portfolios with the ones hedged with optimal puts, unless the ones hedged with optimal collars have net potential returns greater than 1.93x the net potential returns of those hedged with optimal puts.

We also make an adjustment to the net potential returns of any securities hedged with optimal collars that can also be hedged with optimal puts. Because those "AHP" securities generated returns 37% higher than non-AHP securities in our tests, we increase their potential returns by 37% to reflect that. The securities with the highest net potential returns after those two adjustments are the primary ones Portfolio Armor uses to populate your hedged portfolio.

Next, we cap each collared position at its calculated potential return. At this point, you may wonder why we don’t cap each collared position at its lower expected return, since, as we mentioned above, the expected return represents a more likely return, and since a tighter cap would result in lower hedging costs. The reason is that a significant portion of returns are driven by collared securities that exceed their expected returns, and we determined empirically, through backtests, that the benefit of capturing those outliers via caps set at the potential return is greater than the benefit of reducing hedging costs by setting caps at the lower expected return.

Portfolio Armor fine-tunes its selection based on the size of your portfolio in order to minimize costs. Where possible, it will use cash substitutes to minimize leftover cash and increase your portfolio's net expected return.3

An All-Weather Approach

Portfolio Armor's hedged portfolios can generate attractive returns during bull markets, and strictly limit your downside during sharp bear markets. Because our universe of more than 3,000 securities includes exchange-traded products such as inverse ETFs that can generate positive returns during long market declines, this can be used as an all-weather approach. During a long bear market, securities with the highest net potential returns may include bearish ETFs. Of course, you would be presented with optimal hedges for these, so if the market reversed direction while you held them, your downside risk would be strictly limited.

Sample Portfolio

Consider the case of an investor with $1,000,000 to invest, who wants to maximize his expected return while limiting his downside risk over the next six months to a drawdown of no more than 18%. After clicking on the "Create Hedged Portfolio" tab in Portfolio Armor, he would be presented with the input screen below, where he would enter in the dollar amount he wants to invest (1000000) and his "threshold", the largest decline he is willing to risk over the next six months (18).

Create hedged portfolio

Had an investor done this at the close on August 11th, 2015, after a few minutes of processing, he would have been presented with the hedged portfolio below.

Hedged portfolio

Note that, in the hedged portfolio above, each of the hedged underlying securities, with the exception of Regeneron Pharmaceuticals, Inc. (REGN), is hedged with an optimal collar. REGN appears twice in the portfolio, once, as a primary security, hedged with an optimal put, and once as a cash substitute, hedged with an optimal collar with its cap set at 1%. Because of the different ways they are hedged, the two REGN positions have significantly different hedging costs and expected returns.

The maximum drawdown possible with this hedged portfolio is 16.88%: if every underlying security in this portfolio went to zero before its hedges expired, this portfolio would decline 16.88%. The hedging cost of this portfolio is 0.22%. The net potential return of the portfolio is 18.32%, meaning that if every underlying security hit our bullish performance estimate over the next six months (an unlikely scenario), the portfolio would return 18.32% net of hedging costs and taking into account the cap on the cash substitute position. The expected return of the portfolio (which represents a more likely scenario), net of hedging costs, is 6.77%

If you look at the positions in the hedged portfolios in the sample backtests below, you'll see that none has more than five hedged underlying securities at one time, while the sample portfolio above has eight. The reason is that the sample backtests start with $100,000, and the sample portfolio above starts with $1,000,000; Portfolio Armor limits the number of underlying securities in hedged portfolios based on the dollar amount to be invested.

Sample Backtests

The following backtests show performance of Portfolio Armor's hedged portfolio method at various thresholds. In general, the higher the threshold (i.e., the greater the downside an investor is willing to risk over each 6 month period), the higher the compound annual growth rate (CAGR). During the backtests, to be conservative, put options were purchased at the closing ask price, and calls were sold at the closing bid price; options were exited at the midpoint of the closing bid-ask spread, or their intrinsic values, whichever was higher. Because hedged portfolios were graphed at their exit prices, and trading costs were deducted, the starting values shown for the first hedged portfolios in each backtest are less than $100,000.

Backtest: $100,000.00, 2% Threshold

(Each portfolio in this backtest was hedged against a greater-than-2% decline)

Portfolio Armor CAGR: %

Value: $

Show/Hide Positions

Cash: $

Comparison (SPY) CAGR: %

Value: $

Backtest: $100,000.00, 8% Threshold

(Each portfolio in this backtest was hedged against a greater-than-8% decline)

Portfolio Armor CAGR: %

Value: $

Show/Hide Positions

Cash: $

Comparison (SPY) CAGR: %

Value: $

Backtest: $100,000.00, 14% Threshold

(Each portfolio in this backtest was hedged against a greater-than-14% decline)

Portfolio Armor CAGR: %

Value: $

Show/Hide Positions

Cash: $

Comparison (SPY) CAGR: %

Value: $

Backtest: $100,000.00, 21% Threshold

(Each portfolio in this backtest was hedged against a greater-than-21% decline)

Portfolio Armor CAGR: %

Value: $

Show/Hide Positions

Cash: $

Comparison (SPY) CAGR: %

Value: $

Backtest: $100,000.00, 22% Threshold

(Each portfolio in this backtest was hedged against a greater-than-22% decline)

Portfolio Armor CAGR: %

Value: $

Show/Hide Positions

Cash: $

Comparison (SPY) CAGR: %

Value: $

Maybe You Can Do Better?

If you have your own proprietary security selection method, it’s possible that you could generate even better returns using a hedged portfolio strategy. We can build and backtest a hedged portfolio strategy for you using our hedging algorithm and your security selection method, or, a combination of your security selection method and ours. For inquiries, feel free to contact us.

Disclosure:

Our hypothetical backtested returns start at the beginning of 2003, because this was the first point at which we had complete options data to conduct our tests. Hedged portfolios were run for six months, or until all positions had been exited, whichever came first, and then the ending dollar amount of the first portfolio was used as the starting dollar amount of the second sequential portfolio, and so on, until the end of our data series on 4/30/2014. Hedged portfolios contained between 1 and 5 hedged underlying security positions.

When there were no securities available with positive net potential returns (usually, because hedging costs were too high), the last portfolio ending dollar amount was held as cash until the start of the next hedged portfolio. During these periods, we treat the cash as if it were held in a non-interest bearing account, so the dollar amount invested remains constant until the start of the next hedged portfolio. Within hedged portfolios, residual cash positions were treated as if they were invested in a money market fund, earning the yield prevailing at the time (during much of this time period, that yield was negligible).

Within hedged portfolios, positions in underlying securities were entered at their unadjusted closing prices, with trading commissions of $7.95 deducted.4 To facilitate performance tracking, the dollar amounts allocated to these underlying securities were converted to the equivalent numbers of each security at its adjusted closing price on the start date of the portfolio.5 Underlying security positions were exited at their adjusted closing prices, with trading commissions of $7.95 deducted.

During the simulation, to be conservative, puts were purchased at the closing ask price, and calls were sold at the closing bid price; options were exited at the midpoint of the closing bid-ask spread or their intrinsic value, whichever was higher ("last" prices weren't used because in many cases with options, the last price might be weeks old). Each time options positions were entered or exited, a trading fee of $7.95 + $0.75 per option contract was deducted.

Positions were generally held for six months or until their hedges expired, whichever came first. To facilitate performance tracking, positions in underlying securities that split within a few months of being added to a hedged portfolio were exited on the last trading day prior to the split. Also to facilitate performance tracking, certain options that didn’t have complete price histories under one symbol (such as pre-standardized LEAPS) were eliminated from consideration. Eliminating these options likely increased the hedging cost of our portfolios slightly and, consequently, reduced their returns slightly.

Backtested hedged portfolio performance varied depending on starting dates: in the backtests shown on this site, we started searching for a new hedged portfolio on the same date we exited the previous one. In some cases, delaying the start of that search by one day resulted in lower performance. But in no case did any hedged portfolio decline by more than its threshold in our backtests.

For the SPDR S&P 500 ETF (SPY), shown in our graphs for comparison purposes, adjusted shares were used to track performance. In this simulation, $100,000 was invested on the start date, and dividends and any other distributions were reinvested for the duration of the backtest. No trading fees were deducted from the SPY position.

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Footnotes

  1. Maximum drawdown (or, max drawdown) is the most a portfolio would decline if each of its underlying securities went to zero before their hedges expired.
  2. You can also enter your own investment ideas. Enter the symbols of the stocks and ETFs you already own, or enter ones you've found via your own research. Enter your own expected returns for each security, or let Portfolio Armor calculate them for you. Portfolio Armor will present you with an optimally hedged and allocated portfolio designed to maximize your net expected returns given the investments you entered and your risk tolerance.
  3. A cash substitute is a security that, when hedged with an optimal collar with a cap set at 1% or the current 7-day yield on a leading money market fund, whichever is higher, has a minimum downside risk less than or equal to your threshold, a low hedging cost, and a net expected return greater than the current 7-day yield on a leading money market fund.
  4. This was done because the unadjusted prices correspond with the options prices on the same dates, enabling calculations of hedging costs during the security selection process.
  5. Because of this, the interactive portfolio holdings below each graph will often show odd lots of shares in underlying securities. These represent numbers of adjusted shares.