Three Effective Tools For Controlling Portfolio Risk Without Relying Purely on Fixed Income

Many investors are looking for new ways to effectively hedge portfolio equity risk without relying exclusively on mid and long term fixed income investments. Although almost all portfolios should have some exposure to ‘high quality’ fixed income (investment grade and US treasury securities), using these bonds exclusively to hedge the equity side of a portfolio is not as advantageous as it once was.

When 10 year treasuries were paying 4%-6% as they were for the 1990s and most of the 2000s these types of bonds made for a near perfect hedge to equities. In addition to having a moderately negative or near zero correlation to stocks, they provided the investor a 4% to 6% guaranteed return every year. Essentially this was paying investors for very effective insurance.

During 2011 we got another reminder that high quality fixed income can be a great hedge even though 10 year treasuries were only yielding around 3.5% early last year. A holder of the most interest rate sensitive bonds available (very long duration zero coupon treasury bonds) was up around 66% at the exact market low on October 1 2011 while the SP 500 was down around 14% for the year. Holding these bonds provided a near perfect hedge for an equity investor, where even if the investor was invested 80% in the SP500 and 20% in these type bonds they would have actually been up around 1% or so, as the SP500 was down 15%. In addition this ‘insurance’ did not cost the investor anything; in fact he was paid 3.5%/year in implied yield for holding these bonds.

Holding these bonds (or most high quality fixed income) now in any large percentage of the portfolio poses quite a different risk/return prospect. With prices up and yields much lower the efficiency of fixed income as an equity hedge has decreased significantly (although as stated before it is very important in almost all portfolios to still have some exposure to these bonds).

This creates a problem for many portfolio managers and investors who want to keep portfolio risk reasonable but do not think a large allocation to high duration fixed income will achieve the same goals it has in the past.

Our firm, Traphagen Financial Group (www.tfgllc.com) has researched many ways of reducing equity risk and we feel 3 strategies are worthy of portfolio inclusion. These ‘hedging’ strategies are held in addition to our traditional fixed income allocation.

The first strategy works off of ‘mean reversion' and high volatility; it is called ‘Emerald’.

Mean reversion reflects the fact that all available information at any given time is being priced into the market. In the very short term this means if the market has been up in the recent past it tends to go down and vice versa. If you can take advantage of this ‘up and down' short term reversion to the ‘mean' you can ‘collect' positive returns from constantly trading this movement. Emerald does just that.

The kicker is, during times of extreme market stress, volatility tends to increase dramatically and mean reversion goes into overdrive. In 2008 for instance huge swings both up and down (even though the overall index decreased by 38%) created the perfect environment for Emerald. During this period the Emerald index was up 35% effectively negating the S&P 500 equity losses. And since this mean reversion is present during all periods, when the market is tame Emerald still tends to produce positive or neutral returns (albeit much less than in stressful times).

Another hedge we employ is an option based strategy that allows for 100% upside participation in the stock market to a certain level, and provides 15% downside protection. The math here involves estimates of long term yearly equity returns and comparing to what the upside is limited to over the duration of the strategy. Currently we are able to fully participate in approximately 10%/year equity returns (which meets or exceeds our estimates for likely returns) while adding a 15% defense on any downside.

The last option strategy we use involves purchasing normal long equity positions (JNJ, MSFT, AAPL, WMT, etc.) and then eliminating 80% - 100% of the ‘market’ or systematic risk using a combination of bearish options (long puts/short calls) on the general market. This creates a return that will only reflect the difference of returns between the general market and the individual securities held. Assuming the individual securities outperform over time this can create positive returns independent of overall market direction.

Traphagen feels this combination of strategies will provide significant downside protection and risk reduction to a diversified portfolio without significantly limiting long term upside potential. All these strategies have merit on their own, but when combined the interaction of all hedges along with traditional asset classes should provide an excellent risk/return profile appropriate for a market environment with very low fixed income yields and unique worldwide debt risks.

For more information on Traphagen’s suite of portfolio strategies please call 1-201-345-5155 or visit www.tfgllc.com.