Following Up on Hedging Strategies

Two months ago, while expressing some concern about the markets, I played around with ways to hedge the risk of news-driven volatility in a portfolio. I formed some portfolios that were hedged dollar for dollar with a short position in the index. I looked at using the biggest 52-week losers among index components, those yielding at least 3% and trading at new lows, and the ones trading below book value. I also had one portfolio that used F scores, but that one ailed almost out of the box and was discarded.

The results are informative, and I want to review them and share some other observations about the portfolios. I am also going to rebalance and continue testing this approach.

The portfolio of stocks at new lows didn't work that well. Overall, the mix had a two-month return of -1.76%. As the market rose 10%, the long positions gained just 6.59%. Although 16 of the 20 stocks went higher, the four losers averaged more than 11%, with GameStop ( GME) and Lexmark ( LXK) leading the way on the downside. I am going to keep tracking this one to see how it performs when we finally have a down cycle in the market. For this long-biased portfolio, the short-term results are disappointing. If you were leaning short two months ago, as many were, this approach saved you a ton of cash.

The portfolio of stocks trading below stated book value did well in the rally. Overall, the fully hedged portfolio gained 4.53%. Nine of the 11 stocks went higher for an unhedged gain of 19%. Unfortunately, since we used stated and not tangible book value, Alpha Natural Resources ( ANR) was in the mix, and those shares declined more than 34%. Stocks such as First Solar ( FSLR), Phillips 66 ( PSX) and NRG Energy ( NRG) led the way higher with huge gains in the two-month period. If you were long-biased but nervous, this approach has worked OK for you so far.

The stars so far are stocks that were the largest 52-week losers. This was a portfolio that was long stocks that were down more than 50% in the last year, hedged dollar for dollar with a short index position. The portfolio gained 6.28% over the two-month period. The unhedged portfolio of losers would have shown a gain of 22.67%.

Although six of the 15 stocks continued to move lower, those that rebounded flew. Sprint ( S) more than doubled. First Solar was up nearly 80%. MetroPCS Communications' ( PCS) stock price is more than 60% higher than it was just eight weeks ago. This portfolio strategy may have value for nervous investors who are looking for hedged exposure to an uncertain market. It's early in the test, but I will be carefully watching developments in this portfolio.

It is also instructive to look at the stocks without a hedge. Traders may want to start focusing more on stocks in the index that are falling knives with large 52-week losses instead of the momentum darlings. These issues have rebounded sharply, rising far more than the broad market.

In today's low-volume, short-term-trading-dominated market, once the fundamental sellers such as mutual funds and institutional asset managers are done exiting the stock, there are few natural sellers left. When the index buyers and traders move into the long side of the market, the buying pressure in the absence of sellers causes short-covering and spectacular rallies. With no fundamental selling taking place, these issues should track the market or even outperform slightly on the downside.

A reduction in the number of natural sellers and an absence of retail investors means that losing stocks may revert to the mean much faster than years past. At least that's the theory, and I plan to continue tracking the results of these portfolios.Hedged mechanical portfolios are not part of my regular activities, but this is a fascinating subject. In addition, I suspect there is valuable information to be garnered by tracking and testing these ideas.

At the time of publication, Melvin was long S, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.

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