The big drop in world markets after the United Kingdom's
shocking vote to leave the European Union is only the latest
reminder that investors need a variety of eggs in their portfolio
baskets. Large caps, small caps, Asian stocks, European stocks,
high-yield bonds, oil, copper--practically everything took a dive.
The same happened in 2008. Not only did large-capitalization U.S.
stocks lose 37% of their value, but real estate, commodities and
foreign stocks tanked as well. Real diversification demands assets
that don't move up and down in tandem.
You need a strategy for softening the impact of market setbacks.
Using hedging strategies will usually produce slightly lower
returns over the long run, but, in my view, the smoother ride you
get in return is worth the cost. I would be happier with a 6%
return year after year than a 25% gain one year and a 10% loss the
The traditional wisdom for hedging a portfolio is to buy bonds
to temper the ups and downs of stocks as well as provide consistent
income. Medium- and long-term Treasury securities, with maturities
ranging from, say, seven to 15 years, have thrown off interest of
about 5% annually over the past century, with no risk of default.
So a portfolio with half of its assets in Treasuries and half in a
diversified bundle of U.S. stocks has produced long-term returns
averaging about 7.5% annually. Even better, in no 10-year period
over the past 90 years has such a portfolio ever lost money,
according to Morningstar.
Investors, however, face two big hurdles: Bonds today are not
paying 5% interest, and U.S. stocks seem unlikely to match their
long-term average return of 10% per year. The 10-year Treasury is
yielding 1.49%. If you believe stocks will return a few percentage
points per year less than they have in the past, a 50-50 portfolio
will, on average, return less than 6% a year.
There is, however, another solution. You can substitute
for some of your bond holdings. An alternative is an asset class
that moves out of sync with the stock market. One popular example
is gold. On June 24, the day the outcome of the U.K. vote to leave
the EU became known, SPDR Gold Shares (
, $126), an exchange-traded product that tracks the price of the
commodity, rose 4.9%, while SPDR S&P 500 ETF (
, $209), which tracks Standard & Poor's 500-stock index, fell
3.6%. In 2008, when the S&P 500 ETF plunged 36.8%, the Gold
fund gained 5.0%. In 2013, when the stock market ETF soared 32.2%,
the Gold fund sank 28.1%. (Prices are as of June 30.)
Gold and stocks sometimes move together--as in 2009, 2010 and
2012--but, generally, they orbit different planets. Although I'm
not a fan of gold, it is clear its meanderings aren't determined by
the same forces that move stock prices.
Shift to neutral
Another example of an alternative investment is the
, whose manager tries to take market risk out of the picture by
constructing a portfolio that balances long and short positions.
Longs are simply traditional stock purchases, made in the hope that
prices will rise. When you go short, you borrow a stock from
someone else, sell it immediately, and then hope it declines in
value so you can buy it back and return it when it's worth
less--and pocket the difference.
In a market-neutral fund, a manager may go long with one stock
and short with another one in the same sector, making a profit if
the long does better than the short. For example, a manager might
decide that Coca-Cola (
) is superior to Pepsico (
). She buys $1 million worth of Coke stock and shorts $1 million
worth of Pepsi stock. Over a year, let's say that the overall
market is up, and Coke rises by 20%, but Pepsi increases by just
5%. The fund makes a $200,000 profit on Coke stock and suffers a
$50,000 loss on Pepsi stock, for a net gain of $150,000, not
including dividends. What if the overall market falls? The fund can
still make money as long as Coke outpaces Pepsi. Say that Coke
declines by 10% but Pepsi drops by 25%; then the fund will lose
$100,000 on Coke but make $250,000 on Pepsi, for a net gain of
Market-neutral strategies are typically the province of highly
paid hedge-fund managers. Some of the best public mutual funds in
this sector require lofty minimum investments and charge high fees.
Vanguard charges just 0.25% a year for its Market Neutral Fund (
), the lowest fee of any mutual fund in the category, but it
requires an initial minimum investment of $250,000. (The 0.25%
figure excludes extra costs involved in selling short.)
Otherwise, the pickings in this category are slim. Among no-load
funds with reasonable minimums, the best by far is TFS Market
), which requires a minimum investment of $5,000 and has an expense
ratio of 1.9% (excluding short-selling-related fees). Over the past
10 years, the fund, which focuses on small-cap stocks, has returned
3.9% annualized. Since 2008, the fund's calendar-year returns have
ranged from -7% to 17%, suggesting relatively low volatility, the
hallmark of a good market-neutral fund. By contrast, the range for
SPDR S&P 500 ETF was -37% to 32%.
Also consider the approach of the Merger (
) and Arbitrage (
) funds to alternative investing. Each buys shares of
already-announced takeover and merger targets, with the goal of
capturing the last few percentage points of appreciation between
the post-announcement share price and the price at which the deal
is consummated. The result is modest, bond-like performance that is
utterly divorced from the overall stock market and that exhibits
little volatility. In 2008, the annus horribilis for stocks, Merger
was down 2.3%; Arbitrage fell 0.6%.
Finally, you can invest in companies whose business is
relatively isolated from the economy as a whole. One prime example
is reinsurance. Property-and-casualty insurers don't want to bear
the entire risk of shelling out payments after a catastrophic
event, such as a huge hurricane, so they buy their own insurance
from reinsurers. The performance of such companies depends, in
large part, on the frequency of major natural disasters--events
unrelated to the stock market.
Warren Buffett is a longtime fan of the business. His company,
Berkshire Hathaway (
, $145), owns Gen Re, one of the largest reinsurers. Berkshire is
broadly diversified, with holdings that range from jewelry
retailing to banking to consumer goods. But, with the exception of
2008, Berkshire's annual returns have diverged nicely from those of
the S&P 500 over the past decade.
For a purer play on the reinsurance business, consider
Renaissance Re Holdings (
, $117). Its stock's returns have diverged widely from those of the
S&P 500 practically every year--by more than 15 percentage
points in five out of the past 10 calendar years. Its volatility is
much higher than that of a merger or market-neutral fund, but so
are its returns, which have averaged 10.2% per year over the past
decade. Others worth a look are Third Point Reinsurance (
, $12), a smaller firm that was launched only five years ago but
benefits from experienced management, and Validus Holdings (
, $49), which has a superb record and sports a 2.9% dividend
Got it? Buy insurance companies for your own insurance.