Build A 'Whatever Happens' Portfolio... Now

By Joseph L. Shaefer :

I sent a note to our clients earlier today that I think may have value for our loyal readers here, as well. I will share my comments to them, but also remind you of the specific funds, ETFs and individual securities we have previously discussed that may be of value in your own investing.

There is no such thing as a "defensive" portfolio of long-only stocks. Stockbrokers who must always keep something new ready to sell will cite utilities, health care and consumer staples as stocks to rotate into to protect against a market crash. Their logic sounds good: "People gotta eat, take their drugs and pay their electric and gas bill, no matter how tough things get."

True - as far as it goes. People gotta eat. But investors don't have to pay 60 times earnings for Chipotle ( CMG ) or 25 times earnings for Whole Foods Market ( WFM ). The earnings for those two companies (or Procter & Gamble ( PG ) or Pfizer ( PFE ) or Duke Power ( DUK ), et al) might continue unabated, but if their P/E falls by half, their stock still falls by half. Are you willing to accept a 50% drop in the value of your portfolio in a correction, smug in the knowledge that you switched to "defensive" stocks?

Me neither. That's why we have built a very diverse portfolio of mutual funds, closed-end funds, ETFs and individual stocks.

For those who have forgotten what declines look like (or have chosen not to remember 2008, 2000, or a number of more distant spells of vertigo) there is no long position in stocks that will protect you. Blue chips will not. They fall just like everything else. Dividend Aristocrats will not. They, like blue chips, are a good long-term strategy, but they offer no protection against a down market.

Gold is iffy. If the reason for the slide is runaway inflation or terrifying world-altering geopolitical events, gold is a haven. But for a decline because, say, the market is simply way overvalued and new buyers are too scared to enter, gold declines with everything else.

Buy and hold will do what buy and hold has always done; allow you to reach the giddy heights of the top of the roller coaster before experiencing the fear (and financial loss) of the downhill slide. The same with index funds that are simply a static position.

There are, regrettably, only two positions (other than the hedges I discuss below) that will keep your profits intact: cash and bonds. Cash will lose its value at the rate of inflation - but then so will every long position. So if cash "loses" you 2% over the course of a year, that still beats stocks, which have declined 10% on paper -- and 12% after allowing for the loss of purchasing power due to inflation. Remember that the next time some tout pushing his ideas on CNBC snorts that "cash is a loser because of inflation." Duh - everything is a loser thanks to inflation, the silent tax.

Protecting Our Portfolio

We have investments in bonds/MLPs/high dividend payers because I believe the catechism that bonds "must" plunge is no longer valid. "Rates can't go any lower than zero" is a valid statement. But just because rates are unlikely to go any lower does not mean they must skyrocket, driving the price of bonds down. Indeed, we are now near the end of the Fed's bond taper, much feared as the catalyst that would destroy bond value, and bonds are up, not down. We don't invest based on someone's opinion; we let the market tell us what to do.

Bonds may provide relief in that, if they are of very short duration, they will not decline any more than cash would, but they also pay at least something in interest. If inflation is 2% and your bonds only paid you 2% in interest, at least you stayed in place rather than losing 2%, 12%, or more. To everything there is a season.

I tend to favor high active share, short duration, and relatively small (thus nimble) mutual funds for the bulk of our bond portfolio. I want active management in these times (also offered by some of our bond ETFs) and I want managers whose fund is small enough to be able to take advantage of anomalies without disrupting the market. In this area, we own Riverpark Strategic Income (RSIVX,) Rivernorth/Oaktree High Income (RNOTX,) Pioneer Short Term (STABX,) and Blackrock Secured Credit (BMASX,) which owns a portfolio of senior bank loans that typically rise along with interest rates. The ETFs we own in this include Pimco Dynamic Credit (PCI,) Market Vectors Hi Yield Muni (HYD,) iShares 1-3 Year (CSJ,) iShares Investment Grade Corporate Bond ETF (LQD,) and Peritus Hi Yield (HYLD.)

In the international credit arena, I am again long our old favorite Emerging Markets Sovereign Debt ETF (PCY) and Pimco Foreign Bond - Dollar Hedged (PFODX.) I can easily make the case that many emerging markets have higher credit ratings than many developed nations and deserve even higher ones; it is only inertia and rating through the rear-view mirror that keeps this from happening. Would I rather own debt issued by developed nation France or developing South Korea? Spain or Poland? Greece or Latvia? Personally, I prefer nations with a hard-working populace, recent experience with the "workers paradise" of socialism, and no albatross of welfarist public coddling. I'll take France, Spain and Greece for the weather and the Republic of Korea, Poland and Latvia for nations that will repay their debts honestly. PCY fits that bill. And PFODX, by hedging the US dollar at roughly 80%, provides access to numerous developed and developing markets but mitigates the risk that the dollar will decline relative to those other currencies.

Hedging Our Portfolio

We have investments that will actually offer a degree of protection in the event of a decline, like long/short mutual funds and ETFs and inverse ETFs that go up when the market is down. We also seek, in this category, countries and regions whose stock markets have historically and recently had a very low correlation to US markets. In US market decline, almost all US stocks will follow suit. But other nations' markets may not.

For example, many of the nations that have a low correlation with US markets are in the Asia-Pacific region. Australia, Malaysia, Japan, Singapore, South Korea, Taiwan and, of course, China, all have correlations of 32% or less. Instead, they have high correlations to each other, not surprising in that there are substantial trade, cultural and familial connections.

China shows the lowest correlation to US markets, at just 5%. Please understand that a low correlation to US markets doesn't mean that China won't fall as much as US markets fall, or for the same period of time; it merely means that they are unlikely to fall just because the US market is falling. Our trade with China is not so intertwined that a bashing to one economy is mirrored in the other.

In the area of hedging against a decline, we own long/short mutual funds like Robeco Boston Partners Long/Short (BPRRX,) Aston/River Road Long Short (ARLSX,) and Marketfield (MFLDX - now a load fund; no-load when we bought it.) We also own ETPs Barclays S&P Dynamic (VQT) and PowerShares S&P 500 Downside Hedged (PHDG) for the same reason.

Among inverse ETFs, we stick with only the biggest with the best liquidity and volume. We own ProShares Short Dow 30 (DOG) Short Russell 2000 ([[RWM]] - small caps) and Short QQQ ([[PSQ]] - the Nasdaq 100.)

Within the universe of ETFs poorly correlated with US markets, we have selected the iShares MSCI Pacific ex-Japan ETF (EPP,) iShares MSCI Australia (EWA,) and iShares China Large-Cap (FXI.) EPP covers the entire Asia-Pacific region except Japan; EWA the most resource-rich nation with the lowest transportation costs to China, India and the rest of east Asia; and FXI holds only the 25 biggest Chinese companies. Crony capitalism is the oil that lubricates the machinery in China and these are exactly the type of firms that have so much cash sloshing in and out that a few yuan here or there lining the pockets of the well-connected are just so much decimal dust. Most are state-owned or state-controlled.

If EEP, EWA and FXI sound too risky to you, you might want to consider the iShares MSCI Emerging Markets Minimum Volatility (EEMV.) It tracks an index that is a subset of about 200 stocks from the larger universe that comprises the MSCI Emerging Markets Index in order to create a low-volatility portfolio. Low-volatility strategies outperform portfolios with larger price fluctuations over the long term. And it does this with a lower standard deviation than the parent index. But, caveat emptor! Lesser volatility does not mean no risk. A lower drawdown is nice, but if the market falls 30% and this (or any other hedge) falls just 15%, it still hurts.

The Long Side

We still have long positions in the sectors we think will do better than the market on up days and be 'somewhat' more resistant to decline on down days (like health care and basic materials.)

If we are concerned about a weakening market, why have any long positions? Two reasons: (1) The market has a long bias, rising 2/3 of the time and falling, albeit with greater velocity, only 1/3 of the time. You don't want to be caught shorting America when good news comes out. And (2) those of us who believe the market is overvalued could be right on the facts but wrong on the timing. Markets always over-shoot on both the upside and the downside. Who's to say, this time, a market at a CAPE ratio of 24 times earnings (clearly over-valued on an historical basis) won't still go to 30 times CAPE earnings?

In this area, we are still long - mostly -- health care, real estate, basic materials, energy, industrials and pipeline and infrastructure MLPs. Regrettably, both mutual funds we favor in the MLP space have loads for retail investors. If you are a client of a Registered Investment Advisor, however, there is no load, so you may want to ask if they have reviewed these for you. The first is Salient MLP & Energy Infrastructure (SMAPX), the other is Advisory Research MLP & Energy Income (INFRX.) An ETF, with no load of course, which comes close to these two (but not quite!) is Global X MLP & Energy Infrastructure (MLPX.) For our sector selections, we are again sticking with the biggest with the best volume and liquidity: Vanguard REIT ETF (VNQ) for real estate; Select Sector SPDR Health Care (XLV) for health care, Select Sector SPDR Materials (XLB) for chemicals and other basic materials; Select Sector SPDR Industrials (XLI); and Select Sector SPDR Energy (XLE).

Sometimes we need to step back from examining the bark on a particular tree in able to see the whole forest. Portfolios such as the one I've constructed for myself and our clients, above, may "seem" like a hodge-podge, but we have purposely crafted it for capital preservation, for taking advantage of undervalued markets, for what we see as a misperception about bonds, and for the beginnings of downside positioning while still keeping a toe on the long side in what we think are the best sectors.

The Fine Print: As Registered Investment Advisors, we believe it is our responsibility to advise that we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund one year only to watch it plummet the following year.

We encourage you to do your own due diligence on issues we discuss to see if they might be of value in your own investing. We take our responsibility to offer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we "eat our own cooking," but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.

Disclosure: The author is long PCY, PHDG, VQT, VNQ, XLB, XLI, XLV. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Also long all mutual funds cited above.

See also What Does A 'Good' Chinese Adjustment Look Like? on

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

In This Story


Other Topics


Latest Markets Videos


    Seeking Alpha is the world’s largest investing community. Seeking Alpha has unparalleled breadth and depth: from stocks, ETFs and mutual funds to commodities and cryptocurrency, including thousands of stocks (such as small-caps) not analyzed elsewhere. Written by investors for investors, more than 7,000 contributors publish 10,000 investing ideas every month.

    Learn More