Nvidia Booth At Computex Taipei
You Could Have Owned This Portfolio Instead
In June, we criticized Fairholme Fund (FAIRX) manager Bruce Berkowitz for riding Sears Holdings (SHLD) down for years, and we mentioned our Marketplace service as an alternative for readers open to a different approach (Interview With The Dogcatcher). With Sears tanking Monday on the news that Berkowitz was stepping down from its board, we decided to look back on a hedged portfolio we shared with our subscribers a few days before our Sears article in June. Here we update the performance of our top names hedged portfolio from June 16th, with a focus on Nvidia (NVDA) and its hedge.
Our June 16th Hedged Portfolio Featuring NVDA
Each week, we present three portfolios to our subscribers. One is the $100,000 portfolio with the highest ratio of potential upside to potential downside, another is the highest ratio $1,000,000 portfolio, and then we present a $1,000,000 portfolio comprised of our top names. This was our top names portfolio. The idea here was for an individual to hold a concentrated portfolio designed to maximize his potential upside while strictly limiting his downside risk to a drawdown of no more than 9%. This is what Portfolio Armor presented us with, given those parameters:
In addition to Nvidia, the site included Activision Blizzard (ATVI), CSX (CSX), IAC/InterActive (IAC), JD.com (JD), Lam Research (LRCX), and TAL Education Group (TAL) as primary securities, based on their net potential returns. The site attempted to allocate roughly equal dollar amounts to each of those names, but rounded down the dollar amounts to make sure it had round lots of each stock.
In its fine-tuning step, it selected Yandex N.V. (YNDX) to absorb as much of the remaining cash as possible. That’s what “cash substitute” refers to in the portfolio: it doesn’t mean this is a cash equivalent (of course, it’s not); it means it’s a security that when collared according to your risk tolerance with a tight cap (the site uses 1% or the current money market seven-day yield, whichever is higher) has a potential return greater than the current money market rate. The point is to minimize your cash level because cash offers negligible returns and, because each position in your portfolio is strictly hedged, you don’t need cash to ameliorate your risk.
Our June 16th NVDA Hedge
Note that each of the underlying securities was hedged. On our website, each of the “+” signs in a portfolio can be clicked to expand the hedge. Here’s a closer look at the hedge on NVDA:
As you can see above, Nvidia was hedged with an optimal, or least expensive collar, as were the other primary securities. This is in contrast to other recent portfolios, where some primary securities were hedged with optimal puts. Portfolio Armor tries hedging securities both ways, estimating the net potential return both ways, taking into account the historical incidence of outliers. Essentially, the lower hedging cost of collars is weighed against the chance for higher upside when hedging with puts. In the case of Nvidia and the other primary securities here, the collar won out.
Nvidia’s Performance Since (Unhedged)
Recall in our hedged portfolio above, Portfolio Armor estimated a potential return of 22.4% for NVDA over the time frame of the hedge (which expires in mid-December). It’s been four months since the portfolio was created, but so far, NVDA has outpaced our estimate, having gained 30.53% since.
NVDA’s Performance Since (Hedged As Above)
First, let’s look at the current quotes on the options in NVDA’s hedge above, then work out how it has done since, taking into account the hedge. Here’s the relevant part of the option chain for NVDA via Fidelity:
The columns we’re concerned with there are the ones labeled Bid, Ask, and Strike. The way we value options when tracking performance is to use the intrinsic value or the midpoint of the bid-ask price, whichever is lower (we don’t use last price since options often don’t trade every day and the last price can sometimes be unrepresentative of what you’d be able to buy or sell the option for now).
Recall that the call option in our NVDA collar hedge was the $190 strike one. Since NVDA closed at $197.93 on Monday, the intrinsic value of that option was $7.93. On the bottom left of the image above, you can see it has a bid price of $17.30 and an ask price of $17.65. So we value this at $17.475, and since we had 8 contracts covering 800 shares, the call position as of Monday would have cost about $13,980 to buy-to-close.
The put option in our hedge was the $150 strike one, which you can see at the top right of the excerpted option chain. Since NVDA closed well above that on Monday, that put had an intrinsic value of $0, so we value it at the midpoint between its bid price of $0.76 and its ask of $0.80, which is $0.78. And since we had 8 contracts covering 800 shares, that comes out to $624.
In general, the value of a hedged position equals the value of the underlying security, plus the value of the put options you own on it, minus the value of the call options you’re short on it (if any). So the value of the NVDA position in our portfolio, as of June 16th, was $121,296 (800 shares @ $151.62) + $14,920 – $6,400= $129,816.
And the value as of Monday was $158,344 (800 shares @ $197.93) + $624 – $13,980 = $144,988.
$144,988 represents an 11.7% gain from $129,816. Nowhere near as high as NVDA’s unhedged return, but an attractive return so far, nevertheless.
As you can see, this is a bit tedious to calculate manually, so we’ve created an automated tool to track performance in hedged portfolios. Let’s use it see how this portfolio has done since.
Hedged Portfolio Performance Since
Here’s how the entire portfolio has performed since June 16th:
The portfolio as a whole was up 7.41% as of Monday, net of hedging cost and opening trading fees for all positions. Over the same period, the market, as represented by the SPDR S&P 500 ETF (SPY), was up 5.22%.
Note, though, that SPY and this portfolio don’t start at the same dollar amount on the left side of the graph. SPY starts at $1,000,000, but this portfolio starts at $996,003. Our portfolio starts $3,967 in the hole, due primarily to our assumption that we enter each option position at the worst end of its spread. As one of our Marketplace colleagues commented to us recently, this is a very conservative assumption.
Performance Of Our Primary Securities, Unhedged
What if you had just bought our 7 primary securities in this portfolio, each of which were in our top 10 on June 16th? If you bought equal amounts of each of them, you would have been up 25% by Monday.
Our Top Names > Our Hedged Portfolio > SPY > FAIRX
Readers of our recent article on our security selection method (Seeking Alpha? Here’s Alpha) may not be surprised by the strong performance of Nvidia and our other top names included in this portfolio. That they outperformed our hedged portfolio in a rising market shouldn’t be a surprise either, due to the drag of hedging. But what might be a surprise is that our hedged portfolio outperformed SPY (and FAIRX, for that matter) over the same time frame, and did so while taking far less risk.
In a worst-case scenario – if another 2008-style crash happens over the next couple of months, SPY or FAIRX might be down 40% or more. A handful of our top names, unhedged, could be down much more than that. In that scenario, the NVDA hedged portfolio shown here would be down 8.49% at most. You have a shot at decent returns when the market is doing well, and you won’t lose much when it’s not. Heads you win, tails you don’t lose too much.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.