Unscientific but Effective Hedged Portfolio Experiment

 | Feb 22, 2013 | 5:00 PM EST
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As the market continues to confuse and confound the vast majority of participants I thought it would be a good time to go back and check on my hedged portfolio experiment. I have been tracking two portfolios, one of stocks in the S&P 500 (SPY) that are down more than 50% in the past year and one of index components that are lagging the market and trade below book value.

I have not been as scientific with the tracking and rebalancing as I should have been but I find the results to be none the less informative. We need to see how the approach holds up in a severe decline but so far it works fairly well delivering solid returns with lower volatility.

The hedged book value portfolio is up 3.5% since being reformatted in the first week of November versus a market return of 6.5% over the same period. That brings the one-year return for the portfolio up to 12%. That just about matches the indexes return over the past 52 weeks. Matching the market return with dollar-for-dollar hedge consisting of a short index position is pretty impressive in my opinion.

The biggest loser portfolio continues to be the all-star performer. A portfolio with an equal dollar amount of the index sold short as the hedge returned 11.25% since November. Given the general up direction of the market last year the portfolio was concentrated with just 4 stocks and the short index position so it was more volatile than the book value portfolio but still less so than the market itself. The total return since the experiment started a year ago is well above the broad market at 19.54%.

The performance on unhedged basis is spectacular enough that looking at book value laggards and big losers should be in every trader's arsenal. The biggest loser's portfolio of four stocks is up 28.93% in a very short period of time. Three of the four stocks were up with Abercrombie and Fitch (ANF) and First Solar (FSLR) leading the way with gains of around 50%. That brings the annul total to an almost unbelievable return of 98.35%.

Of course without the hedges in place you would have had some wild volatility but doubling your money by buying the losers in a year suggests that the losers list should be monitored by most traders.

The more sedate index components below book value returned a less spectacular 13.67% since November. That brings the total return so far to 47.3% which is still not too shabby compared to most traders' results and the market itself. Sixteen of the 17 stocks in the portfolio moved higher during the test period as the laggards caught up and surpassed the market itself.

Once again the returns suggest that paying attention to the cheaper less-loved stocks in the index makes more sense than chasing the market leaders for traders and investors.

In reassembling the portfolios this morning I see that the index laggards trading below book value once again has 18 stocks in the portfolio. As might be expected it is a very energy heavy portfolio with eight of the stocks coming from the oil and gas sector. Some of my favorite energy names like Nabors (NBR), WPX Energy (WPX) and Chesapeake (CHK) make the laggard list. So does my favorite long term stock story Corning (GLW).

Surprisingly there are no banks this time although three insurance companies do give financial a presence in the portfolio. For a complete list of tickers just send me an email. I will form a test portfolio of an equally weighted $100,000 long portfolio with $100,000 of SPY sold short and see how we do over the next couple of months.

The falling knives portfolio is even more concentrated with just three stocks this time around. Only Cliffs Natural Resources (CLF), Advanced Micro Devices (AMD) and Apollo Group (APOL) are down 50% over the past 12 months. That's a pretty ugly mix of stocks and could provide a real test for this method. I will spilt my test portfolio between these three names and sell an equal amount the index against the concentrated long portfolio.

My study and review of the hedged portfolio using components of the S&P 500 has not been scientific enough nor rigorous enough to reach a definitive conclusion on its worth. It has however provided some valuable information that should provide food for thought for traders and investors.

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