History of the Hedge. Every quarter, I do a writeup on my portfolio, so I can recall what I was thinking and review previous mistakes. Here are excerpts from the quarterly reports, starting with the Q2-2007 one. Apologies for the repetition, but I wanted each quarterly writeup to stand alone.
Q2-07: (hedge 1.0%) I started a small hedge position, comprising S&P 500 index puts with various dates going out about a year, and various strike prices around 1200-1300. The purpose of the hedge is to make it safer for me to use debt and margin to buy stocks. The portfolio yield has stayed in a band from 20% to 30%/year, after tax, for a couple of years now. I can borrow money at an after-tax rate of under 6%. Why not borrow at 6%, earn at 25%, and pocket the difference? The answer of course is risk; a serious bear market could easily reverse that 25% to minus 25%. There is also the risk of a margin call, disrupting the portfolio by forcing me to sell great companies at depressed prices. But if there is a serious correction or bear market, those S&P index puts will become extremely valuable, giving me something besides good stocks to sell to meet margin requirements. It may sound like I'm going way out on a limb, but I'm not. I'm limiting my margin debt to about 20% of capital. The hedge, incidently, is actually currently making a profit, since I bought the puts at market peaks. However, my fervent hope is that hedge expires worthless. It is strictly insurance against severe market corrections.
Q3-07 (hedge 2.8%) I slightly increased my hedge position in S&P 500 index puts with strike prices around 1250, and I will keep it going as long as I'm using margin debt. Currently margin debt is around 30%. Oddly, I've actually made a small profit on the hedge, since the S&P 500 has gone down a little since I started it. With the present combinination of high returns (32%) and high margin debt (30%), I feel quite comfortable paying the 2%/year or so that the hedge is likely to cost me for insurance. At some point, I will pay off the debt, and rethink whether the hedge is a good idea.
Q4-07 (hedge 6.8%) The Portfolio is fairly highly leveraged right now, at about 35% margin loan. This leverage was mostly taken after the big Nov. drop in the market, to pick up bargains. Hopefully, the 6.8% of S&P 500 index puts will give sufficient protection against margin calls if the market tanks in 2008.
Q1-08 (hedge 13.1%) I entered the quarter more than fully invested, about 130%, and ended it about 150% invested. I wasn't very active...Actually my S&P 500 index put options were up more than anything else on a percentage basis this quarter, 48%, but I consider them insurance rather than a for-profit investment.
Click here for Part II