Hedging Doesn't Have To Be A Drag
Hedging Isn’t The Hard Part
After the Global Financial Crisis, I wanted a simple way to figure out how to hedge, so I worked with a financial engineering post-doc to develop Portfolio Armor’s hedging algorithm. Just input the maximum drawdown you’re willing to risk, and it shows you the least expensive way to hedge that level of risk.
The Hard Part Is Generating Good Returns
That seemed hard at the time, but in hindsight, it was the easy part. The hard part was generating good returns while hedging. You can see that for yourself at the bottom of this page on our website, where we track the returns of our hedged portfolios: the number circled in red is the average 6-month performance of the most aggressive hedged portfolios we track, those hedged against >40% declines, and the number in blue is the average performance of the SPDR S&P 500 Trust (SPY 0.00%↑) over the same time frames.
An Eight-Week Run Of Extraordinary Performance
Take a closer look at the last eight weeks in that table though. Each hedged portfolio (red) hasn’t just beaten SPY (blue), it has trounced it.
What’s Driving That Outperformance
Probably, three different things are at work here:
Luck (Let’s be honest).
The power of concentrating in a handful of our top names, rather than diluting with diversification. Each hedged portfolio has no more than eight underlying securities, so when we pick a big winner (as we did with Super Micro Computer (SMCI 0.00%↑), it has a big impact.
Our security selection method is starting to get dialed in.
Luck is self-explanatory. Let’s take a closer look at the other two elements here.
The Power Of Concentration
This was our portfolio hedged against a >40% decline as of September 21st, 2023.
What our algorithm did there is, roughly, three things:
Select seven securities (all stocks, in this case, but its universe isn’t limited to them) it estimated would have the highest returns, net of hedging, over the next six months.
Find the optimal way to hedge them against >40% declines.
Round down roughly equal dollar amounts of the seven names to round lots of them, and use a tightly collared position in Nvidia (NVDA 0.00%↑) to absorb most of the leftover cash and lower the overall hedging cost of the portfolio.
How That Worked Out
Like this. Very nicely. That portfolio finished up 50.5%, net of hedging and trading costs, while SPY finished up 21.54% over same time frame.
Our Security Selection Method Getting Dialed In
Here’s a table of the factors we use to calibrate our security selection method.
Let’s take closer look at the number circled in red. That’s the factor we apply if a security can be hedged with puts (and not just with collars) against a single-digit decline.
What that’s saying is a security that, historically, a security that can be hedged that way generates a 6-month return ~2.95x higher than one that can’t be hedged that way, so when our system finds a stock or ETF like that, it boosts it up in our daily ranking accordingly.
How That’s Working Out
You can see the performance of our top ten names (unhedged) here. Their eight-week run out outperformance is driving the eight-week run of outperformance of our hedged portfolios.
Maybe It’s Not Just Luck
Picking a winner like SMCI could have been attributed to luck, but the odds of our system picking that along with Affirm Holdings (AFRM 0.00%↑), Marathon Digital Holdings (MARA 0.00%↑), and the ProShares Ultra Semiconductor ETF ( USD 0.00%↑), as our system did on August 17th of last year, seem slim.
How Long Will This Run Continue?
Probably until there’s a major market rotation, at which point our performance may lag for a bit until our system locks into the new market trend. But whatever happens, your downside in our hedged portfolios will be strictly limited.
If You Want To Stay In Touch
You can scan for optimal hedges for individual securities, find our current top ten names, and create hedged portfolios on our website. You can also follow Portfolio Armor on X here, or become a free subscriber to our trading Substack using the link below (we're using that for our occasional emails now).