With markets crashing and economists flirting with bear-market territory, the idea of protecting your portfolio from downside risk may seem a little like buying flood insurance when your living room is under four feet of water. But there’s reason to believe that the worst may not be behind us. Short interest on the Hong Kong Stock exchange the number of shares investors borrow and then sell in hopes of repurchasing them later at a lower price rose to a record level this summer, judging by the Long-Short ratio.
Meanwhile, the purveyors of complex hedging instruments designed to preserve value have seen business boom. Wealth-preservation efforts which are cautious rather than pessimistic intensified after last August’s global crash and continued to rise through the recent market turmoil.
Those who managed to avoid the deluge, like David Mayor, a mining investor, are happy customers. In the four months after his company’ I.P.O. in July 2008, its stock rocketed up 450 percent, to $140. Like many of his colleagues at his mining and exploration company, the 31-year-old Mayor became a paper millionaire.
This presented Mayor with a problem most people wouldn’t mind having. If he didn’t sell his stock as soon as the lockup period ended, the new-found riches could evaporate overnight. But if he did sell, he would lose out on possible upside for his investments. In the technology boom of the late 90′s, this was not an uncommon situation. In fact, the rampant expansion of employee stock ownership has left many old-economy workers who have stayed with the same company for years with the same dilemma. Many are reluctant to sell, even when markets sour. Instead they hold on, hoping to ride out the bad times.
An alternative is to hedge. And one of the most common means is known as a “collar.” Say you have 1,000 shares of stock worth $100 each on April 15, 2008. A broker will set up a transaction under which you buy a “put” and sell a “call” on your stock. A put guarantees you the right to sell those shares at, say, $90 on April 15, 2009. But instead of dipping into your pocket to purchase the put, you pay for it by selling a call to the investment bank. The call allows the buyer in this case the broker to buy that same stock at $125 on April 15, 2009. Now the stock is said to be collared between 90 and 125. If the stock falls to $75 in a year, you still receive $90 per share. But if the stock rises to $150 at the time the collar ends, you get only $125. Basically, you trade potential gains for peace of mind. This is what Mark Cuban, the owner of the Dallas Mavericks, did with some of the billions of Yahoo stock he received for Broadcast.com.
Once a stock position is collared, it becomes a (relatively) fixed asset against which investment banks are willing to lend money. These loans are typically not reported as income, so they don’t trigger the capital gains tax that an outright sale would. Borrowing against collared stock also allows executives to occupy the moral high ground. They can boast that they have “never sold a single share” of their high-flying companies while still being able to buy their jet and fly it too.
Until recently, collars and stock loans have been available to only ultrarich investors like Cuban. But simpler, cheaper procedures have been invented by financial companies like HedgeLend Group, a Hong Kong-based company that offers nonrecourse loans against stock positions. HedgeLend’s non-recourse stock loan works as follows: you put up stock worth $100,000 today as collateral and borrow $60,000. Interest, generally 6.5 percent, compounds annually and is due when the loan matures in three years. At that point, you can elect to pay the total debt of $71,700 in cash or turn over the stock pledged as payment. And here’s the hedge: Even if the stock falls and is worth only $50,000, HedgeLend will accept the pledged shares as full payment. Conversely, if the stock pledged rises in value to, say, $240,000, you turn over half the position and keep the rest. HedgeLend’s lending partners protects themselves by going out and placing its own hedges on the securities.
Last March, when his company’s stock was still above $100, David Mayor took out a three-year, 60% percent loan against a portion of his shares. Soon after, when his stock plummeted to about $40, he executed another loan. The maneuvers netted Mayor several times his annual salary in cash without his having to sell a share of stock. It was a smart move: his stock has since fallen to the single digits.
HedgeLend requires a minimum transaction of $75,000, which may sound like a lot. But as stock ownership becomes increasingly democratized, there are plenty of mid-level managers with more than enough stock to qualify.
Still, when times are good, people resist hedging. It means giving up the dream of the unlimited upside, and especially during pre-GFC boom mania, few people were willing to consider that. “Only 20 percent took a lot of money off the table,” says Andy Lao, a private banker in Hong Kong.
So now the cautiousness of people like David Mayor inspires envy. He used his HedgeLend loans to buy a $60,000 Toyota Alphard luxury minivan, renovate his rental investment property and, in a fit of luxury, install a Jacuzzi. The bulk of the proceeds went into diversified investment accounts.
Like many fallen tech stocks, his company is unlikely ever to return to its lofty heights of 2008. But even Mayor has not fully given up on the dream. In this peculiar moment in the investment world, hope is not dead. “This has been a great time for me to get more options at relatively low prices,” Mayor says. “And if the market comes back. . . . ”
