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Investing In Airlines Without Nosediving

Summary

Two alternatives for airline investors are to pick individual airline stocks or to purchase shares of an airline industry ETF.

The ETF ameliorates stock-specific risk via diversification, but allocates only small amounts to some of the most promising stocks.

We present a 3rd alternative: using the hedged portfolio method to create a concentrated portfolio of top airline stocks that strictly limits stock-specific as well as other kinds of risk.

The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down. --Warren Buffett

It's customary to quote Warren Buffett's bearishness on the industry when writing about airline stocks, and the Buffett quote above, from the 2007 Berkshire Hathaway (NYSE:BRK.B) shareholder letter, is my favorite. Seeking Alpha contributor Harm Elderman chose another good one in his recent article on the US Global Jets ETF (NYSEARCA:JETS) ("Time To Re-Examine JETS: The Airline ETF"). Elderman's article is worth reading in full, but this graphic he included does a great job of laying out the way the JETS ETF is diversified. That diversification, as Elderman notes, offers an interesting tradeoff.

Elderman points out that, due to the way JETS is structured, particularly in the second point in the graphic above, his top airline pick at midyear, Hawaiian Holdings (NASDAQ:HA), as a second-tier domestic airline, only gets a 4% allocation in the ETF. So a JETS investor would have gotten relatively little benefit from HA's 35% year-to-date performance. On the other hand, had HA done as poorly as another airline mentioned in Elderman's article, Avianca Holdings (NYSE:AVH), which is down nearly 67% year-to-date, its impact on JETS' performance would have been similarly limited.

Nevertheless, as Elderman points out, JETS has outperformed the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) year to date, up 6.13%, as of Tuesday's close, versus DIA, which was down 1.24% over the same time frame, so it may be worthy of consideration for investors looking for exposure to the airline industry without incurring the risk of picking a handful of airline stocks on their own. In this article, though, we'll look at a third way of investing in airline stocks, one that can give us bigger exposure to stocks like HA, but with less risk than owning the ETF.

When Stocks Can Be Safer Than An ETF

It may seem counterintuitive that owning a handful of airline stocks could be safer than owning an ETF that holds dozens of them, but that can be the case when you hold those stocks within a hedged portfolio. Although JETS ameliorates stock-specific risk via diversification, it's still subject to industry risk and systemic, or market risk. You can strictly limit your potential downside due to any of those risks with the hedged portfolio method. Below, we'll show how to use that method to construct a concentrated portfolio of airline stocks using JETS' top holdings as a starting point, for an investor who is unwilling to risk a drawdown of more than 20%, 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 30% decline will have a chance at higher potential returns than one who is only willing to risk a 10% drawdown. In our example, we'll be splitting the difference and using a 20% threshold (less than a third of the drop AVH shareholders have experienced so far this year).

Constructing A Hedged Portfolio

We'll recap the hedged portfolio method here briefly, and then explain how you can implement it yourself using JETS' top holdings as a starting point. Finally, we'll present an example of a hedged portfolio that was...


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