How to Hedge Against Summer Risks?
Who are we?
The Investment Team consists of 50 ambitious international students of the University of Groningen. All students have an affinity with the financial world and a profound interest in investing. Collectively, the team manages a diversified portfolio comprised of equities, derivatives and other financial instruments. Once a month we meet to discuss macro-economic trends, current portfolio holdings and new investment opportunities. After each meeting we have a beer at the bar with our fellow investors.
In this week’s article of the Risk Magazine we provide a brief review of our realized returns, we disclose current portfolio holdings, and motivate the structure of our portfolio in preparation for the summer period.
The Summer Strategy
As the last meeting of the RIT took place on the 28th of May, everyone takes a well deserved holiday, and so does the Investment Team. We will come together again in September, meaning the portfolio is left as is until then. Historically, markets can be quite turbulent during the summer.
The red arrows in the figure illustrate the downwards movement that is seen surprisingly often during the summer. Recently, Jeroen Huijgens has written a great article that covers this ‘Sell in May, and remember to come back in September’ phenomenon.
Over the years, multiple strategies were used by the Investment Team in order to cover the summer risk. Last year, the Team chose Flow Traders equities as their preferred hedge. Flow Traders is a market maker in the ETP (Exchange Traded Products) market. This includes all types of index products. The firm continuously offers bid and ask prices and profits off the difference. The higher volatility in the stock market, the more profit Flow Traders makes. Since volatility brings risk and thus overall lower returns, Flow Traders is generally perceived as a strong hedge. 2017 as a whole, however, saw very little volatility in stock markets, and did not result in a profit for the Investment Team.
This year, we chose a different approach. Our Summer Strategy consists of two parts which we will discuss separately: a put option and exiting a few of our positions.
First, the put option. After our lasting meeting, a large share of our portfolio was listed on the AEX index. Consequently, our portfolio is likely to move similar to the AEX index. By betting against the AEX we can hedge against general downwards movement of the Dutch stock market and so we did. The figure below shows a general outline of the put option we bought.
Specifically, it was one contract of the Mini AEX Option, or MOA, with a strike price of 540 and expiry date August 17 2018. Option contracts generally cover 100 shares of the underlying product. Since the AEX floats around 550 points, a regular option would have been expensive at premiums of 800 euros. The MOA only covers 10 shares of the underlying, making it an affordable strategy. The following scenarios are possible:
Increase in AEX by x%: We still gain some, but lose the premium paid -> €-84.5 +x%*portfolio
AEX does not move: Again, we lose the premium paid but gain no profits on individual stock -> €-84.5
AEX decreases by x%:We lose individually on our Dutch portfolio, but our put increases -> -x%*portfolio - €84.5 + x%*AEX decrease. Break-even at 532.
Admittedly, the put option does not make a perfect hedge. To further minimize our risk exposure, we voted on the sale of risky positions. One of our positions that we collectively decided to close was Hunter Douglas (HDG). Hunter Douglas is a Dutch firm whose primary business is the sale of window coverings. While the company itself may not sound that familiar, their well known product, Luxaflex, might ring a bell. Now, the main catalysts for acquiring a position in HDG were the undervalued share price, the synergies gained from the numerous acquisitions, as well as a growing middle class which is the primary customer segment for HDG.
Every meeting, the our control group gives advice on keeping or selling a position in our portfolio. To do so, the control group makes an analysis regarding our current holdings and presents its findings to the team. The underlying motivation for the proposals of the control group are based on the catalysts. If it turns out the catalysts no longer prove valid, it can be the correct move to exit the position. Moving back to the case of Hunter Douglas, the control group came to the conclusion that despite the numerous acquisitions between in 2017 and 2018, investors did not think the value of HDG sufficiently benefit. This means one of the original catalysts fell short, so we agreed on closing our position.
EUV: the golden ticket of ASML
Managing risk is an important task in investing, but the main goal is to get those sweet returns. A great example was our position in ASML. ASML Holding manufactures lithography machines that are used in the production of computer chips. The particular business is very dependent on economic prosperity as ASML’s performance is strongly correlated to the demand for products using computer chips. As economic growth worldwide is very strong, the demand for telephones and computers is high. This is was one of the reasons for taking a position in ASML in February 2018.
Stock price movement of ASML
The main catalyst is the proprietary technology developed at ASML: EUV. Extreme ultraviolet lithography(EUV) is a technology that allows the manufacturing of chips at a very small scale. ASML is a near monopolist in the market for EUV machines at a market share of 85%. In the words of Warren Buffett: “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price”. Generally, companies that operate in a monopoly-like situation will see excessive returns. In the graph that shows the stock price in the months ASML was in our portfolio, the green arrow is where the position was initiated. The black arrow points to the moment where we closed the position. Our final return was approximately 14.5%.
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