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A Lower-Risk Way To Invest In The Dow

Summary

During the average 6-month period over the last 10 years, the Dow-tracking ETF DIA gained 3.98%.

DIA shareholders suffered a 38% decline during one of those 6-month periods.

A hedged portfolio of Dow component stocks, such as the one shown below, can offer a higher expected return with less than half the drawdown risk.

Although cost is a concern when hedging, in our example, the hedged portfolio has a negative cost.

Risk Versus Return For The Dow-Tracking ETF

Although not as widely-traded as ETFs tracking the S&P 500 and the Nasdaq, according to the ETF Database, the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) is among the top-40 ETFs by average trading volume over the last 3 months, and has assets under management of over $11.5 billion, so it holds a place in the portfolios of a lot of investors. Any of those investors who owned DIA in late 2008 and early 2009 saw the ETF drop about 38% within a six-month period between August of 2008 and February of 2009. During the average six-month period over the last ten years, though, DIA investors had a respectable total return of about 3.98%. But as we'll show below, by using the hedged portfolio method to invest in some of DIA's top holdings, an investor can get a higher expected return over the next six months while risking a drawdown less than half as large as the one mentioned above.

When Stocks Can Be Safer Than An ETF

It may seem counterintuitive that you can be exposed to less risk by holding a handful of Dow components than by holding the ETF that owns all of them, but that can be the case when you own those stocks within a hedged portfolio. Although a diversified limits the idiosyncratic risk of owning individual stocks, it doesn't limit market risk (DIA isn't as diversified as some ETFs, as it has about half of its assets in its top-10 holdings). But a hedged portfolio limits both. Below, we'll show how to construct a hedged portfolio out of DIA top holdings for an investor who is unwilling to risk a drawdown of more than 19%, and has $500,000 that he wants to invest. First, though, let's address the issue of risk tolerance, and how it affects potential return.

Risk Tolerance and Potential Return

All else equal, with a hedged portfolio, the greater an investor's risk tolerance -- the greater the maximum drawdown he is willing to risk (his "threshold", in our terminology) - the higher his potential return will be. So, we should expect that an investor who is willing to risk a 29% decline will have a chance at higher potential returns than one who is only willing to risk a 9% drawdown. In our example, we'll be splitting the difference and using a 19% threshold (half of the 38% drawdown DIA investors experienced in 2008-2009).

Constructing A Hedged Portfolio

We'll recap the hedged portfolio method here briefly, and then explain how you can implement it yourself using DIA's top holdings as a starting point. Finally, we'll present an example of a hedged portfolio that was constructed this way with an automated tool. The process, in broad strokes, is this:

  1. Find securities with relatively high potential returns.
  2. Find securities that are relatively inexpensive to hedge.
  3. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns).
  4. Hedge them.

The potential benefits of this approach are two-fold:

  • If you are successful at the first step (finding securities with high expected returns), and you hold a concentrated portfolio of them, your portfolio should generate decent returns over time.
  • If you are hedged, and your return estimates are completely wrong, on occasion -- or the market moves against you -- your downside will be strictly limited.

How to Implement...


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