Sunday, March 9

Week 140 - Build Your own Hedge Fund

Situation: You want to invest for retirement in such a way that your retirement income grows faster than inflation. The only way to do that is with stocks. But the only way you can be confident your retirement income will grow faster than inflation almost every year is to construct your portfolio as a hedge fund. That means you want your portfolio to lose a lot less than the stock market during downturns yet make almost as much during upturns. So, the risky stocks in your portfolio will have to be backed 1:1 with US Treasury Notes. 

Let’s build a workable portfolio of stocks and US Treasury Notes, and keep it simple. You’ll want stocks issued by the 12 largest companies that are Dividend Achievers (see our Table). Four of those (CVX, XOM, UTX, MMM) have a 5-yr Beta that exceeds 0.67, meaning those stocks could be down a lot just when you start your retirement and, therefore, need to be backed by an equivalent investment in 10-yr US Treasury Notes. There are 4 entries for T-notes in the Table to account for that.

Then, we’ll need to see how much it will cost you to apply automatic “dollar-cost averaging” as the safest way to build your portfolio. Yes, you’ll over-pay some months but that will be balanced by the months you under-pay (it’s what statisticians call Reversion to the Mean). The only way you can do that with an income of ~$100,000/yr is to go online and put a small amount of money regularly (say $60/mo) in each of the 16 lines of investment in the Table, for a total of $960 per month. (If you make less money, decrease the lines of investment by half (to 8 from 16) for the first ten yrs, then invest in the other 8 over the next 10ears. $960/mo for the full portfolio sounds like a lot. But I’m sure you know by now that at least 10% of your gross income has to be set aside for retirement. Otherwise, you’ll be setting aside 20% after you reach age 55. 

If you have a 401(k) or 403(b) plan through your employer, allot half to the available stock index and half to the available bond index. Then supplement those funds with parts of the portfolio in the Table that you’ve had your accountant declare to the Internal Revenue Service to be your IRA.

How much does the portfolio cost? Looking at Columns L-P in the Table, you’ll see that 2% of your yearly investment goes to expenses. Total returns over the past two market cycles (Column C in the Table) for this plan have come to ~8%/yr, which leaves an estimated 6%/yr gain if you’d been in the plan since 2000. However, your fixed costs (2% of each year’s expenditures) carry less weight with time because the value of the investment has more than doubled since 2000. In other words, the expense ratio for the plan drops to less than 1%/yr after you’ve been in the plan for more than 9 yrs.

What’s not to like? Well, you have to keep track of which 12 companies are the largest Dividend Achievers. You’ll probably need to add a company every 5-10 yrs, which means you’ll have to start a dividend reinvestment plan (DRIP) in that company and stop adding money to one of the existing DRIPs. You’ll also need to remember not to sell the DRIP you’ve dropped (no pun intended), unless that company fails to increase its dividend for two consecutive years. Another problem is that Treasury Notes purchased through treasurydirect don’t have automatic reinvestment of interest payments. But the Treasury website offers a couple of advantages over DRIPs: 1) There is an “inflation-protected” alternative to all of the standard offerings; 2) Savings Bonds offer total returns that approximate those for 7-10 yr Treasury Notes, and pay interest that is automatically reinvested (like a DRIP). More importantly, taxes are deferred on interest accruals until the Savings Bond is redeemed. In other words, Savings Bonds work like an IRA. You save money by not having to pay taxes until after you spend the money. 

To simplify your life, cover each monthly investment in one of the riskier DRIPs by an equal investment in Inflation-protected Savings Bonds (ISBs) instead of 10-yr Treasury Notes. For example, the Table shows 4 such companies, stock investments which you'd like to hedge by putting $240/mo into an ISB. (But that becomes $250/mo because ISBs come in $25 gradations.) A final problem is that computershare only provides DRIPs for 11 of the 12 companies in our Table. If you choose to purchase 3M stock each month, you'll need to set up a DRIP through Wells Fargo.  

OK, how do we know this portfolio will act as a hedge fund? If you’ll refer back to our Week 117 blog, you’ll see that a hedge fund is defined by hedge fund traders. It’s in the eye of the beholder. That means it is composed of assets that hedge fund traders are rarely tempted to bet against (or "short"); they’d rather own them. That means the portfolio ideally has to a) beat the hedged S&P 500 Index (VBINX in the Table) over both the short term (5 yrs) and long term (2 market cycles, Column C), b) lose less than the 28% that VBINX lost during the 18-month Lehman Panic, c) have a 5-yr Beta that’s less than the 0.67 long-term average for the hedge fund industry, d) pay at least a 1.5% dividend, and e) have a trailing P/E no higher than 20. Now look at Line 18 in the Table to see that the portfolio we’re proposing exceeded those 5 requirements in every area except 5-yr Total Return (Column F). That small lag in performance during the unusually strong bull market of the past 5 yrs is more than made up for by outperformance in the safety areas (Columns D & I).   

Bottom Line: If you go to the trouble to set up this portfolio, and have the discipline to stick with it through thick and thin for 10+ yrs, you’ll come out ~2%/yr ahead of simply investing in our benchmark, which is the hedged S&P 500 Index (VBINX in the Table). But it will take a couple of market cycles to reach that success because a) your expenses in the first few years will be too large a fraction of your net asset value, and b) the advantage gained over the benchmark by having all your stocks in a category that grows dividends much faster (see Column H in the Table) takes time to have an impact. But, from the outset you’ll be facing less volatility. The portfolio in the Table had average losses during the 18-month Lehman Panic of 11.3% vs. 28% for VBINX, and the current 5-yr Beta is 0.5 vs. 0.93 for VBINX

Risk Rating: 2

Full Disclosure: I make automatic online monthly investments in WMT, NKE, JNJ, IBM, KO, XOM, and PG. I also own stock in MCD, CVX, PEP, UTX, and MMM.  I hedge investments in XOM, CVX, UTX, and MMM with equal investments in 10-yr and 20-yr Inflation-protected US Treasury Notes.

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