I wrote about Baupost's (Seth Klarman's) Hedging Strategy based on his view in 1995-1997. In a recent speach he updated his thoughts on insurance (hedging).
"Do you overpay for insurance — or do you go uninsured?
Klarman: In terms of our firm, I tried so hard to learn
the lessons of 1998 in particular, which were: Don’t be
unprepared for something out of the blue that’s really bad.
To some extent, we were prepared this time. However,
you can never be prepared enough. We had a lot of macro
protection in terms of credit default protection on bonds
where we were just betting that credit spreads would widen.
That’s been incredibly helpful. But we’ve gotten really tired
of buying market puts, or anything like that, because they
inevitably are expensive and expire worthless.
So as an investor, you have terrible trade-offs. Do
you overpay for insurance — or do you go uninsured?
That’s just one of those dilemmas for which there are really
no perfect answers."Outstanding Investor Digest March 17,2009
Lots of blogs have been linking to Seth Klarman's Annual and mid year statements
lodge with the SEC from early 96 to the end of 2001.
There hasn't been much analysis of the filings. Put Option Strategy
I looked over four of his filings from Oct 95 - Apr 97. Over that period his put contracts ranged from 0.5% - 2% of assets. In the 0.5% case, I expect it's because the market ran away from him. It seems likely that his target is 1%-2% of assets.
In early 95 the majority of his puts were on the Russell 2000, by late 95 they focused on the S&P 500. By 96 they focused on the Nasdaq 100.
New positions appear to be placed at around 10%-15% below market. The days to expiry started off at about 305 in early 95 and had dropped to about 140 by late 96. This is easily explained by volatility. By late 96 he was buying Nasdaq 100 puts. In 6 months the Nasdaq 100 had risen by 16%. In such an environment you want to purchase puts with less duration as the value of duration declines as the market rises. This is offset by the discount you get for buying duration when rises are small but crosses over as the market moves away from your position.
Are 1-2% of assets enough to hedge? Yes. In late 95 the fund had $89M in assets. Assuming 20% was in cash then 72M is exposed to market moves. Let's assume that Seth is buying insurance against a substantial move of 30% or more and that the loss on the invested portion will only be 20%. This is reasonable as value investments generally outperform on the downside (even though they didn't necessarily in the current bear market). The portfolio would have lost $14M and the hedge was worth 11M. In 96 losses would have been around 16M and the hedges worth 21M. As noted previously, the Nasdaq 100 puts got away from him and only offered about $6M in protection from a $20M loss.
Based on a 30% drop, the average upside of the put portfolio was about 17 times for each period (using the annual cost of options with < 1 year to go).
When volatility is at historically normal levels, using 1%-2% of your portfolio can provide a reasonable hedge against substantial market drops. Such an approach will reduce the volatility of your returns and provide cash to buy when others are selling. Klarman doesn't seem to be mechanical about his option buying but broadly stays within bounds of 1-2% of assets, a strike 10%-15% below market and a duration of about a year under normal (average) market conditions.