In 2015, our “pooled investment vehicle” (aka hedge fund) The Naked Alpha Fund had its worst performance yet – even worse than 2008. Last fall, we set out to determine why, after the fund’s unit value had fallen 16.9% from the final week of June through September.
We discovered that our mechanism for hedging our stock exposure wasn’t as effective as we’d planned. As just a few of our holdings were plummeting, the indexes that we had purchased insurance against dropping were holding up rather well, comparatively. Our original premise had been that if we sell puts on enough stocks, our portfolio should resemble the S&P 500; hence, buying insurance using S&P 500 Index puts should work.
2015 proved we were wrong in our assumptions. We normally sell puts on 20-30 stocks at a time, giving us a representative sampling of the S&P 500 – that in 2015 proved NOT to mimic moves of the S&P 500 as a whole. Last year, the largest and most influential stocks held up well (see FANG stocks) while a few of our holdings (see TWTR, MU, SNDK, QCOM) crashed as much or more than 50%.
So, in October of 2015, we decided to change the way that we hedge our short put positions. Instead of buying puts on the index, we buy puts on the same stocks that we’re selling puts on. It’s called a “vertical put spread” in the options-trading world. This way, if we sell puts on a stock that plummets, our downside is limited in each and every case.
Where we are today is far more comfortable than 2015 and prior, knowing the downside of each of our positions. We still, however, also initiate cost-less collars for next January, creating additional UN-HEDGED exposure in our portfolio. These collars have on average 18% protection built-in, so it’s fairly benign risk at this point. The benefit of these un-hedged collars is that we participate in much of the upside if the stocks we’re exposed to have a good run between now and January.
What this has all culminated in is the ability for us to predict how the Naked Alpha Fund will react to down markets in the next 30-60 days. We now have a pretty good estimate of what the NAF return will look like if stock markets begin to drop. Here is a snapshot of our estimations for the portfolio as of 5/25/2016:
Stocks down 5% – NAF eeks out approximately +0.8% positive return
Stocks down 10% – NAF will drop approximately 4.5%
Stocks down 15% – NAF will drop approximately 8.6%
Stocks down 20% – NAF will drop approximately 11.5%
Stocks down 25% – NAF will drop approximately 14.4%
This gives not only our clients peace of mind knowing the most undesirable outcomes possible, but due to our hedging methodology change, our manager can better gauge the inherent risk of the portfolio.