This past week’s pull back in the US markets was nothing compared to rest of the world. It appears the US is still the country of choice for investing, but not immune to some pressure. As of yesterday’s close the short-term daily cost was 0.79 basis points and the mid-term out to December dropped to 1.01 basis points per day.  

See data for the past 22 months on our Resources Page

I’ll keep it short today as it’s Friday before Memorial Day. Consider the following: This week Japan saw a single day sell off of 7%. Luckily that was lost in translation by the time the US markets opened, but the cause for it still exists here in the States. If a market inflated by central banks can turn on a dime in Japan, the same kind of risk can exist here. Perhaps the magnitude will be different, but a look at Wednesday’s decline and the lower open Thursday can be equated to an emotional reaction to the Fed meeting notes. To say this market an emotionally driven one would be an understatement.
 
As such, we’re selling puts as a way of entering new positions this week about 5% below the current market and hedging them by buy puts even farther away. We may finally get some choppiness in June and if that’s the case, using a disciplined approach for putting money to work in a hedged fashion should limit our exposure if the end of the bull is near. 

We have updated our performance data here on our blog. It is now current thru December 31,2012. It represents all of the investable assets of one of the author's that has been investing using the Buy & Hedge approach for over 90% of his investable assets.

In general, 2012 was a very good year - despite the cost of hedging in an up market. Basically, the reason these accounts so dramatically out-performed the S&P 500 in 2012 was that the account used credit spreads to control interest in the S&P500. With the cash that was available because of the credit spread, the author invested in high yield bonds and Municipal bonds.

The rally in the bond market in 2012 and the dividend return helped to cover the cost of being hedged - and then some.

Here is the link to the spot on this web site where we post our performance returns. In addition, we are excited to announce that we will start to post our results monthly now - starting with the end of May 2013!

Also, here is the chart and performance disclaimer below:

Chart Description: Chart calculates the Time Weighted Returns for the Author's Portfolio for the Time Period indicated. The Time Weighted Returns are calculated using GIPS standards. The S&P 500 ETF is symbol SPY and the dividends are always re-invested back in to the SPY ETF upon the ex-Dividend date. The chart multiplies $10,000 times the Time-weighted return percentages to show the growth of $10,000 invested in the indicated strategy. The author's GIPS time-weighted returns were calculated using every investment account the author managed himself with the exception of his 401k which had investment options that were too limited to hedge effectively. As soon as the 401k was transferred to an IRA account controlled by the author, then the returns from that account were included in the time-weighted return from that date forward. Further, the author stipulates that one other account that is not hedged is the only account that the author controls that is not included in these returns. That account is invested in alternative strategies and represents less than 5% of the author's total investable assets.

Performance Disclosure:

• Performance results are presented net-of-advisory fees and reflect the reinvestment of dividends and capital gains. Past performance may not be indicative of future results. Therefore, no investor should assume that the future performance of any specific investment or investment strategy will be profitable or equal to past performance levels.
• All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals may materially alter the performance of your portfolio.
• Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for an investor’s portfolio.
• Historical performance results for investment indexes and/or categories, generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results.
• Economic factors, market conditions, and investment strategies will affect the performance of any portfolio, and there are no assurances that it will match or outperform any particular benchmark.

Each month we post information about the high probability credit spread strategy we employ in some of our client accounts. Known as the HPCS on this blog, we sell out-of-the-money vertical spreads to generate small amounts of income that have a high probability for success. To get familiar with our previous posts, here are links to the last four.
 
May HPCS Post
April HPCS Post
March HPCS Post
February HPCS Post
 
*Risk reminder: As we always do, we want investors to know that what you put into a fully allocated spread like this is at risk. That means in the unlikely event that the market moves to the point that both your strikes are in-the-money at expiration, the position losses 100%.  So despite how well this strategy has worked for us over the last 30 months, don’t put any money into it that you can’t risk.
 
One of the pieces of this tactic is that we are always assessing the directional bias of the market. After all, we don’t need to be right about the direction of the market for this to work…we just can’t be REALLY wrong. That means we look to build our position on the side of the market that has the higher probability of success. That means looking at the Bull trade and comparing it to the Bear trade and finding the best return to risk ratio.
 
This seems especially relevant now as we are seeing new highs almost every day. On a high level, our method looks at 3 different factors: Distance OTM (out-of-the-money), Probability risk, and the trade’s return. We look at these factors to help us decide the more advantageous side of the market to place our vertical credit spread. Bullish trades are executed by selling a put spread below the market and Bearish trades are implemented by selling a call spread above the market.  
 
Below is the data we calculated before today’s open using the SPX (S&P 500) as our base index, to help us understand which way our bias will lean on the position we plan to put on in the next few days.

All 3 comparisons tell us that the position with the better chance of success is still the Bullish trade.
 
However, we’ll add an observation here as we watch both sides of the trade throughout the options period. The Bear side of the trade actually has some value and has begun to close the gap on most of these metrics against the Bullish put trade. This may tell us that the options market is beginning to look for an end to the recent rally and the bear trade may actually be the way to go in the near future.
 
Given the choice, we would always lean toward the bear trade. We do this because the risk of a major gap up out of the blue is notably lower than the risk of a catastrophe sell off overnight.  We’re not there just yet, but if you use this method before entering the a new trade use this as a gauge as to where the speculative money is being placed.

We advocate the use of Fixed Income ETFs for portfolios near and in retirement. In addition, we have recommended using fixed income ETFs for your excess cash. We have described the technique for pairing LQD & JNK with put options to modify your target returns while being hedged.
 
The reason we look to hedge the LQD and JNK is that these two ETFs maintain a set duration for the holdings in their funds. They ladder the ownership of the bonds and as bonds mature, they re-invest the funds back in to fixed income further out on the time curve such that they can maintain an average target duration for the overall portfolio.
 
The weighted average maturity for LQD and JNK is just shy of 12 and 7 years, respectively. The result is that interest rate moves will affect the price of the ETF in a material way. Just look at the move up in price for these two ETFs for the last several years. The reduction in interest rates has caused these ETFs to appreciate nicely.
 
When interest rates start to go back up again, the price of these two ETFs will certainly decline as the value of the underlying fixed income held in the laddered portfolio will start to decline.
 
The way to manage against this kind of price risk in your portfolio is to build your own laddered portfolio and hold to maturity to you can re-coup your investment principal. However, this is not an easy proposition for everyone – especially the smaller investor.
 
So, along comes iShares with an interesting new product launch of ETFs in early 2013. They have launched a series of Fixed Income ETFs with a targeted maturity date. All of the fixed income in the ETF mature within a 1 year window specified within each symbol. As the fixed income in the ETF mature, the fund will hold the money as cash and return it all to shareholders and terminate the fund once all of the fixed income pay off.
 
The series is the iSharesBond Corporate ex-Financials Term ETFs. They purchase fixed income issuances from investment grade companies – excluding financials. The symbols along with maturity year are IBCB for 2016, IBCC for 2018, IBCD for 2020, and IBCE for 2023. The team at iShares should be commended also for keeping the management fee for this ETF at only 10 basis points or 0.10%. That is exceptional!
 
Now, with these products, you can build your own ladder all the way out to 10 years. And if you decide to hold on to the fund all the way to maturity, you will receive the fair return of your capital based on today’s interest rates.
 
It is a creative way for the smaller investor to build their own laddered fixed income portfolio that they know is diversified.
 
Just one point of caution: these ETFs were just launched in April 2013 – so they are still small in volume. In fact, they tend to trade at a bid/ask spread that is a little wide for my tastes – and the result is that they trade at a premium to the NAV price. In a fixed income product in a low interest rate environment, you can’t afford to give up too much premium in the price when every little quarter point counts.
 
So, if you want to buy these, I recommend you hold out for the right price. Use the premium/discount calculator on the iShares web site and only look for a fill at a price you can feel good about.
 
I like the concept of a maturing fixed income ETF so that you can structure your own ladder. However, until the volume and AUM increases, you might want to wait on using these products.
 
Good luck!

A series of higher highs continue to define this May as the market pushes upward. The results of which are a maintained low cost of hedging. As of yesterday’s close the short-term daily cost was 0.70 basis points and the mid-term out to December dropped to 0.95 basis points per day.  

See data for the past 22 months on our Resources Page

Despite the S&P being 25 points higher now than where it was a week ago, the cost of hedging has ticked up slightly. The difference in the cost of hedging is minimal, but what is interesting is that it isn’t lower, as typically we’ve seen before.  Why you ask? I’ll share some insights on a discussion I had with one of our clients this week.
 
Imagine you have been long this market since December. That means you were bold enough to brave the worries of the fiscal cliff and held strong in the face of the sequester fears. Almost every day you would probably ask yourself if today’s new high was the time to sell. However you don’t want to try time the market and miss out on more of this run up. After all, you’ve been asking yourself that same question since the middle of March and you’ve been right to stick it out so far. However, you don’t want to be greedy and give it all back if there is a quick turn. So what do you do? The answer is you hedge.
 
Right now locking in gains with a hedge, vs. selling is a way to leave yourself exposed to the upside and limit how much you can potentially give back if the market turns south. The best way to lock in those gains is by buying long puts.  The cost of hedging at a level 10% below the market is 3.5% annually right now and this is the choice many investors are making instead of going to cash by selling. In other words, the worst you could do from here was to lost 13.5% if the market sold off by the end of the year.

However, if you want to tighten up those hedges, you can buy at the money puts for about 8% annually. They are more expensive than the 10% protection that cost at 3.5%, but if the market does correct, you keep even more of your gains for the year because you’re locked with the right to sell at these levels.
 
But there is also another factor that is keeping the longs long. It’s the taxable event of selling now. If you’ve been long for less than a year, the tax treatment is as short term capital gains, which is your income rate. Holding on to those gains for a year will yield a better return in your pocket after taxes by up to 20%. So ask yourself, does it make sense to pay 8% in hedging costs and stay long or sell now and incur a 20% higher tax bill? Before you answer, let me give you one more incentive to stay long…that is if the market does run up and your hedge never gets used, that 8% cost can be counted as a loss and carried over for when you do eventually sell. Convinced?
 
It seems right now, the answer continues to be stay long and hedge vs. selling and going to cash. This is a perfect example of the tail wagging the dog and how a good market can build on itself for no reason except is more efficient to stay long.