I figured today’s rough day in the stock market was a good time to discuss ways I like to protect portfolios in the short-term.
Rule #1 of investing is diversification. By holding a mixture of asset classes, you reduce the risk that your entire portfolio will fall at the same time. However, the market crash in 2008 showed the effects of globalization and technology on various asset classes. Things are so tightly linked these days (a high correlation) that the rules of diversification have changed. A simple portfolio of stocks and bonds may not be enough.
Let’s take a look at what I consider the 3 best ways, right now, to diversify against stock market volatility in the short-term:
- US Government Bonds – Traditionally, US government bonds have been a safe haven during times of economic uncertainty. This still holds true today, but I am concerned of a potential shift over the next few years. Typically, when the economy slows and stocks slide, demand for Treasury Bonds pushes up the price which lowers the yield/interest rate earned on the bond. This increase in price has provided the bulk of gains in Treasury Bonds (and funds) during bear markets in stocks. However, with interest rates near all-time lows, investors have been shying away from US Treasuries in search of higher yields. Yields can only go so low, meaning there is not a lot of room for the price of bonds to move higher. There is also the issue of the growing debt burden of our nation. We can only borrow money if other countries are willing to lend it to us. Countries may not be willing to lend as much money as in the past if we don’t get our fiscal situation under control…
- Foreign Government Bonds – With US Treasury Bonds not as attractive as in years past, I think we’ll start to see the bonds of other nations begin to act as a substitute. Specifically, the emerging nations are in great shape fiscally, with many countries running surpluses each year (what a concept!). Emerging nations do have a terrible track record of currency crises and bond defaults, but I think the current troubled state of most developed nations (the US, Japan and Europe) is slowly changing the destination of investment dollars. Moving forward, I think we’ll see emerging sovereign bonds produce lower volatility and better real returns (after inflation and the extra bump from an appreciating local currency).
- Managed Futures Funds – These funds have been around for over 30 years now, but they’re just starting to gain interest from investors. Managed Futures funds are typically managed by a Commodity Trading Advisor (CTA), with the goal of riding momentum. They’ll use futures contracts to gain exposure to various types of commodities as well as interest rates, currencies and sometimes equity indexes. Historically, they’ve shown a great track record of adding value to a portfolio by offering negative correlations to stocks during bear markets (meaning they go up when stocks go down and vice versa). The reason is because the manager has the ability to profit from both rising and falling prices. Again, their goal is ride momentum, and that means in either direction. During 2008, the Altegris 40 Managed Futures Index posted a positive 15.47% return!
Like stock or bond funds, investors have the option of investing in a professionally managed fund or simply an index fund. If you were planning on adding a fund as a permanent staple of your portfolio, I would go with a professionally managed fund as they tend to outperform the rules-based indexes over the long haul. Personally, though, I think they’re too expensive and not necessary to hold each and every year. The companies that manage these will tell you how important it is to always maintain exposure, but what else do you expect them to say? They want you to invest in their fund. I prefer to use a lower cost index fund and simply add exposure when I become nervous on the economy and stocks. I expect stocks to perform well in the long run – I’m just looking for ways to hedge downside volatility in the short-term.
At the start of 2011, Wisdom Tree came out with an ETF that tracks a Managed Futures Index called the Diversified Trends Indicator. The symbol is WDTI. Looking at its performance since inception might scare investors, but you have to understand how the index works to know why the performance has been so bad. As mentioned, these funds will look to buy or sell (go long or short) futures based on their momentum. During choppy, back and forth markets, like we’ve seen in commodities the past 2 years, the fund is basically buying high after an increase and selling low after a fall – not a good strategy. But, during strong trending markets (like a bear market in stocks), the funds perform very well as they’re able to ride the trend, and that’s what we want!
Please feel welcome to pass this along to anyone you think it would help!
-Nick