I continue to favor 30% Equities (hedged), 30% Fixed Income and 40% Alternative (defined as anything other than traditional buy-and-hold). Find complimentary (low-correlating) ETFs, funds and strategies to build your alternative bucket just as you’d diversify your equity and fixed income allocations.
One of the great advantages advisors and individuals have over large endowments and pensions is the ability to source liquidity quickly. One of the great disadvantages is that many individuals are unable to gain access to exceptional hedge fund managers or private equity funds. Though you can get close enough.
I’m finishing a white paper on The Total Portfolio Solution. I hope to get it published
and up on the CMG Advisor Resource Center soon. The paper looks at combining low-correlating strategies, position sizing and what I call bucket sizing (when to tactically overweight or underweight equity, fixed income and alternative exposures).
Let’s look at hedging your equity exposure today.
Assume that your portfolio is 30% allocated to equities. Further assume that mix is made up of 14% large cap, 5% mid cap, 3% small cap, 3% emerging and 5% international developed equities.
The ETF revolution has created many liquid tools for you and me to use. Once such tool is option contracts on various ETFs like SPY (the SPDR S&P 500 Index).
During periods when the market is expensively priced, consider using put options to hedge out much of your downside risk. Here is one idea:
I favor buying 2% out-of-the-money puts (typically two months to expiration) and at the same time selling 7% out of the money puts. A put option gives you the right to sell a stock or ETF at a defined price. It costs money to buy that right (think of it like downside protection insurance). See video from Investopedia on put options.
If your stock is priced at $100 today, in this example, you could buy a put option that gives you the right
to sell your stock at $98. When the market declines in price, your put option goes up in price. In this example, if your stock declines to $90, you make the difference between $98 and $90. Your stock lost $10 but your hedge gained $8. You don’t have to sell your stock and you protected much of your downside.
Of course, there is a cost to buy the put protection so if you keep on doing this type of hedge and your stock continues to go higher the costs will eat into your long-term gains. So the big question is, just how expensive is it to hedge? The next big question is, when to do it?
I’m in the camp that believes there are some environments that favor hedging and others where there is no need to hedge. When the hamburgers are cheap, no need to hedge. Most of the downside has taken place, risk is less and forward returns much greater. When expensive, like today, hedge.
Statistically, most stock market corrections are in the 5% to 7% range. Given this, I favor buying 2% out-of-the-money puts (a cost) and selling 7% out-of-the-money puts (a credit). Doing this you limit the maximum amount of protection you put in place to 5% but by selling the deeper out-of-the-money puts, you limit the overall cost to hedge your stock exposure. I believe that such an approach may be implemented with close to a zero net cost for the downside protection.
But 5% max protection might not be good enough, you say. I get that, but think in terms of how you might roll that protection down as your stock exposure continues to decline. The goal, of course, is to continue to protect on the way down. You have to manage your exposure and continue to roll your put protection out approximately two months forward (making that adjustment about once every month).
Another approach is to buy 20% out-of-the-money put protection. This is a relatively inexpensive way to protect against the big declines that typically come during recessions. If your stock is at $100 today, consider the $80 put options that mature about three to four months from now. If your stock goes up to $110, roll your put protection to $88 (or 20% below the current prices).
Personally, I favor a combination of writing covered calls along with the 2/7 out-of-the-money put hedging process and when our CMG NDR Large Cap Momentum Index is in a sell, buying deeper out-of-the-money puts or some other form of hedging as risk is then generally higher.
Talk to an options specialist. Your broker-dealer may have one in house or your custodian (Fidelity, TD, Schwab, and Pershing) likely has an options team. Further, learn more about hedging through the CBOE.
Finally, innovation is alive and well. While trading options is easy to do, it requires additional paperwork and may be difficult to implement across a large number of client accounts. Then there is the “try explaining this” to your client challenges. There are mutual funds that buy stocks or index exposure and do some form of active hedging packaged within the funds structure. There are funds that use moving average crossovers to put risk on and take it off. The idea is to mix a number of equity risks in your equity bucket that are hedged and/or add stocks and low fee ETFs that you can hedge yourself.