Hedging Your AmREITs

Most of what I’ve written about hedging is what I know — how a bond portfolio manager hedges a book of mortgage-backed securities.

I hope it’s been helpful for my readers to recognize the styles and methods the managers of these companies use, and their relative transparency and quality of disclosure on this front.

Jon Rosenbaum asked in a comment today:

“What is the best way to protect your principle and retain dividends for amreits? What hedging instruments work best?

What about SDS for general market drops? or some other vehicle?”

Before I take a shot, let me remind everyone that there is no perfect hedge.  Back in the 80’s, the First Boston (today Credit Suisse) traders kept a small potted miniature (English) boxwood near their trading desk with the legend  “The Perfect Hedge”…. Before I let go of the hedging lore from Wall Street, I need to repeat one other bit of wisdom, which, unfortunately, doesn’t answer Jon’s question.

“The only perfect hedge is a sale ticket.”

While true, when you sell your assets, you lose the future income.  That’s the rub for retail investors, and, for that matter, for what we call the “real money” investors like insurance companies and pension funds.  The need for future income overrides the reality that selling the assets may be the best thing to do sometimes.

A portfolio manager or a retired person generally doesn’t have the choice to just sit out during an apparently overheated market, because the insured pool for a life company continues to have claims, the retirees depending on the pension or annuity have to get their monthly checks, and the retiree living off their investments still has to put groceries on the table.

So let me start with what didn’t work for me, since it was perilously similar to Jon’s suggestion of SDS for protection against a general market move.

Back in 2009, I bought at nearly the right time (March), though with not nearly enough of my capital.  By that fall, I was nervous with my gains, and thought a correction was due in all the deeply discounted mREITs, insurance and bank stocks I had bought.

I bought into leveraged inverse financial funds (first SKF, later FAZ) thinking that a general correction of the dozen or more financials I had ridden on the upwave would result in quick profits to offset the losses on the stocks.  To help with the income issue (as I was also writing out-of-the-money calls on some of the positions), I wrote far out-of-the-money calls on SKF.

To make a long story short, I did keep the premium from the SKF calls, but the loss in principal as it collapsed, reverse-split, and kept going down was a largest enough loss to take away most of the gains I had originally sought to protect.

Why is that?

Because of the mathematics of those double and triple levered ETF’s.  They are structured to provide the return for one day only.  If, as is normal, a market does not go in one direction only, but up and down on successive trading days, the levered ETF will lose money overall.

Here’s how it works:

Say you have a portfolio that’s at $100 today, and you buy $50 worth of the double inverse ETF.  If your portfolio went up by 2 points the first day, your inverse would go down by 2 points.

After Day One, your hedge is working.

But on Day Two, let’s say your $102 portfolio drops back down to $100.  Your inverse will go up from $48 by twice the fraction that your long portfolio went down.  That’s just under 2% (2/102), or 0.196%.  Doubling that, the inverse goes up by 3.9216%, leaving its new price at $49.88.  You’ve lost 12 cents due to the mathematics of daily compounding on the ETF.

It’s a mathematical artifact at work.  If the market, and your portfolio value, go up and down over time, if you simply hold the levered ETF, you’ll end up with less money over time.

Having said that, I have had some success this year by buying next month out-of-the-money calls on triple-levered inverse FAZ when the financials have been strong for a few days and political risk is present before the weekend (e.g. Europe PIIGS crisis or the Congressional game of political hostage taking).  When Monday comes, the news is usually enough to move the market up or down at the open.

Maybe a half hour after the open, I either close the option position with smallish loss (the news is good and my main portfolio is up or not being killed), or I look to sell a call option at a higher strike price than the one I bought on Friday (when the news is being interpreted as bad for financials).  Whichever way the news drove the market that morning, by midweek it usually becomes clear that the world is not coming to an end, or that more problems are cropping up in what was supposed to rescue the world.

Since my main bias is toward protecting against disaster, building a position of “vertical” call spreads on FAZ at no cost or even slight profits gives me the kind of disaster insurance I’m looking for.  I have no doubt that the market can punish me more than this small protection will give me, but I just don’t see another method that doesn’t result in losing so much money over time on “hedging” that my net worth goes down rather than up over time.

Hope this helps, Jon.  Feel free to ask more questions.

hh

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6 Responses to Hedging Your AmREITs

  1. Cy Berlowitz says:

    One day only. That’s the ticket for the inverse ETFs. Forget about trying to get your money back. I put a mental stop, and out it goes when the stop is reached.
    If it is way up at the end of the day, I’ll put a real stop on it so I don’t feel I have to wake up before 6:30AM PCT to start the vigil. Good post.

    Cy

  2. Jon Rosenbaum says:

    Hi Howard and thanks for your answer.

    http://finance.yahoo.com/echarts?s=SDS+Interactive#chart1:symbol=sds;range=5y;compare=nly+gspc;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

    I’m looking at this chart. In 2009 SDS way up and S&P way down. Given this chart it looks like SDS is a good hedge against S&P (representative of the general market) collapse. If amreit prices drop with the overall market in a collapse due to Europe debt or whatever, won’t SDS therefore be a good hedge retaining priniciple of net worth in portfolio and also retaining the divs from amreits?

    Any thoughts appreciated.

  3. Jon Rosenbaum says:

    Not sure if anyone is getting this link but basically I compared SDS to NLY and S&P 500 in a Yahoo Finance chart. Look at about 2009. Looks like SDS is a good hedge against but general market drop. Could this work for amreits also?

    Jon

    • hhill51 says:

      Hey, Jon —

      The main reason SDS appears to hedge so well in 2009 is that we had a unidirectional (trending) market. In those markets, the issue of the daily compounding of plus and minus moves in the reference index does not hurt nearly as much as it does in choppy or neutral markets.
      .
      That leaves you with the unhappy choice of making a call on whether the market is moving in a strong directional trend before even deciding to employ one of these levered ETF’s as a hedge.
      .
      Perhaps a better hedge is to decide how much of your expected dividend income you can afford to spend on disaster insurance, and then to buy the amount of calls on SDS (or FAZ or SKF) that you can afford.
      .
      To choose the right options, I would look at the “delta” of the options (around 0.20 seems to have the kind of “kick” I would like), and I would look at buying several months forward. That might make sense as you receive each quarters’ dividends on your amREITs.
      .
      Obviously it won’t be perfect, nor will it be terribly efficient, but the more sophisticated hedge instruments (swaptions, CDS, futures on EuroDollar contracts, etc.) simply aren’t available to us mere human beings.
      hh

  4. Jon Rosenbaum says:

    Very helpful thoughts Howard and thanks.

    I would add that if and when there is a huge, sudden, blow-up in something like collapse of Euro, nuke war in mid east, some calamity somewhere that causes huge drop in the market and fast………..maybe SDS or TWM is the place to be. Who knows when that will/might happen.

    This scenario vs a steady state go nowhere trendline for the stock market in which case I can see the advantages of not being in SDS because of the math you detailed.

    Thanks

    Jon

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