Summary
- The cash hedging strategy discussed in this post is one in which an investor raises cash, to protect against a severe correction, but maintains a high-dividend allocation that is calculated as a proportion of the cash position.
- Let us assume that the investor has $20,000 and wants to have 50% of her portfolio in cash, as protection against a severe market correction.
- We show that, if the investor wants the equivalent of a 2.50% return on the cash, before taxes, she needs to invest only a fraction of the cash in a high-dividend security.
- Often over 80% of her cash is protected. The portion at risk generates the desired yield.
Cash hedging
The cash hedging strategy discussed in this post is one in which an investor raises cash, to protect against a severe correction, but maintains a high-dividend allocation that is calculated as a proportion of the cash position. Cash is raised as investment gains grow together with the perception that the market is overvalued. We assume that interest on “pure” cash is negligible, as it is at the time of this writing.
The high-dividend allocation is calculated as follows: (desired cash allocation) times (desired yield on cash) divided by (high-dividend security yield). The remainder is the actual cash allocation, which is “safe”. The high-dividend allocation is the portion at risk, which earns the equivalent of the desired yield on the entire desired cash allocation.
Let us assume that the investor has $20,000 in a portfolio and wants to have 50% of that in cash, as protection against a severe market correction. The table below assumes that she wants a 2.50% return on the cash portion, before taxes. For that, she invests $1,785.71 in a high-dividend security with a yield of 14%. In this example, over 82% of her cash is protected. The portion at risk generates the desired yield.
AGNC, ORC, OXLC and SRET
Investors may consider using one or more of the following high-dividend securities to implement our cash hedging strategy. These securities pay dividends regularly, typically on a monthly basis.
- AGNC Investment Corp. (AGNC, ), a mortgage real estate investment trust (REIT) with an 8.59% yield (at the time of this writing).
- Orchid Island Capital, Inc. (ORC, ), another mortgage REIT, this one with a 12.98% yield.
- Oxford Lane Capital Corp. (OXLC, ), a collateralized loan obligation (CLO) fund with a 12.86% yield.
- Global X SuperDividend REIT ETF (SRET, ), a high-turnover fund of REITs with an 8.01% yield.
How much cash at risk?
The table below shows how much money would be needed across various high-dividend yield options ranging from 14% to 8%. They cover all of the funds above, in terms of yield. For example, if one were to use SRET, a little over 30% of the cash would have to be invested (i.e., put at risk) to yield the equivalent of a return of 2.5% on the full $10,000.
Final thoughts
Generally speaking, the higher the yield, the higher the risk. Often this is due to leverage being used by the security to generate the outsized yields. Nevertheless, it tends to be safer for an investor to buy a leveraged security (e.g., the ORC) than to borrow money to implement leverage directly. For example, one could get a return on a 4%-yielding security that is significantly higher than the 4% yield by borrowing to buy more of the security – a debt that has to be paid back, with interest.
Many investors like to employ protection strategies other than increasing their cash allocation. A favorite is the use of “put” options. The reality is that these strategies are highly specialized and require much better timing than holding cash – e.g., “put” options are “timed” bets, since they expire at a certain date. Because of these and other constraints, they tend to be less successful.
