Over the past eight years, US stock market prices have continued to climb to heights never before seen. While I don’t want to jinx it, I do wonder how long it can continue. And when trying to design an investment strategy I’m confronted with lots of choices and information. In a world of low interest rates and high stock prices, what’s an investor to do to protect a nest egg? Here is the latest in my confessions of a portfolio strategist with a focus on investing in alternatives.
US Bull Market History
Like Newton’s apple, gravity can affect stock markets, too. What goes up still has to come down. When it comes to investments, this is called “reversion to the mean“. While certain investments may exhibit outsize returns over a short period of time, eventually the returns tend to gravitate back toward the peer group average.
Yet here we are approaching one-hundred months and counting and the bull is still running. There are plenty of reasons why this party has gone on for so long: no major outside shocks to the system like a political crisis or hot war of some sort; global central bank policies have kept interest rates low; low interest rates mean investors have no really good alternative than to buy stocks; companies have remained profitable with low wage inflation meaning little pressure on corporate bottom lines.
As a portfolio strategist trying to develop a well-balanced, globally diversified investment portfolio for retirement clients, I’m wary. I don’t want to fight the market trends but I also don’t want to leave clients over-exposed to risk of loss when an inevitable correction does show up. But on the other hand, I’ve been “burned” by being too defensive each time the market sailed along despite certain fundamental or technical indicators.
How to Hedge Portfolio Risk
The classic way to deal with portfolio risk is through diversification. By placing eggs in several different baskets, you’re not likely to lose it all when bad news hits a few baskets. You mix stocks and bonds from US and international markets in the expectation that when one area of the market zigs another will zag.
You can expand on this by tweaking to have different proportions allocated to large company stocks versus small company stocks or between growth-oriented stocks and value-oriented stocks. But the principle is still the same.
The downside to diversification is that you’re not likely to get consistent, over-sized returns as some of those areas that zig will dampen the returns from the areas that zag.
The World of Alternatives
Advisors use alternative investments for many purposes: to reduce volatility, for downside protection, to generate absolute return, to target reduction in certain riskier assets and more. Depending on what problem I need to solve for, I can use a range of alternatives.
There are all sorts of alternatives to choose from when it comes to investing. The classic ones that are top of mind include real estate, gold, and natural resources or commodities.
Worried about inflation which will sap an investor’s purchasing power? If inflation increases, bond holdings will be worth less. How do you protect against that? The conventional method might be to buy bonds that will mature in the short-term and avoid bonds that will mature ten or more years from now. The alternative way would include buying into funds with floating interest rates or buying stocks that offer a bond-like dividend.
There’s been a growing trend toward using what is called “factor investing“. And I use some elements of factor investing, too.
The most common factors are size of company (large versus small), style (value versus growth), and risk or low-volatility (as measured by ‘beta’). Generally, smaller companies have tended to have higher returns than larger firms probably because they are innovative and not as well followed. Research also notes that over time companies that are more “value” oriented tend to do better than go-go growth stocks (not always the case if you find the next Apple, in which case look to the “small” factor noted earlier).
There are other factors to consider as well like “price momentum”. Like Newton’s First Law of Motion, there’s a theory that if prices are going up, then they will continue to go up and vice versa. This is also embedded in the old stock broker phrase “don’t fight the tape”. So, you can find stock-picking services and even ETFs that subscribe to this model.
Hybrid Hedge Strategies
Personally, I tend to subscribe to a hybrid approach. To a conventionally diversified portfolio, I layer on certain hedging approaches. Generally, I’ll structure a core portfolio to include more of a “value” tilt and add more small cap/value. I’ll also use several different “low-volatility” ETFs like the iShares Edge MSCI Minimum Volatility USA ETF (USMV). And in head-to-head comparisons, I’ve found that the iShares Edge MSCI Minimum Volatility EAFE ETF (EFAV) has performed as well or better with lower downside risk statistics than many other options – including those from Vanguard. But even Vanguard offers something in this area: Check out Vanguard Global Minimum Volatility (VMNVX, Admiral Shares, or VMVFX, Investor Shares).
Another factor that I’ve incorporated has been “dividend-paying” stocks. Research has shown that firms that pay a dividend have done better than those that don’t. And those that have a history of paying increasing dividends have done better than those that pay dividends that don’t increase or have been cut.
In my MarketFlex portfolios I have constructed portfolios that include between one dozen and two dozen individual stocks from a wide range of sectors. What they have in common is a history of paying increasing dividends. These are split between “Dividend Growers”, “Dividend Aristocrats”, and “Dividend Kings.” Here, the difference is between stocks with a short history of growing dividends to Aristocrats that have at least a twenty-five year history of increasing them to Kings that have a 50-year history. All of my back-testing and review of research has shown that these types of stocks have generally weathered downturns better than most other alternatives.
Hedging with Covered Calls and Managed Futures
Another category of alternatives includes covered calls and managed futures. Since I’m always looking for ways to hedge the risk of a client portfolio, I’m open to looking at anything.
As market prices continue to increase, I expect to be adding more ‘covered call‘ positions. A covered call offers an investor a way to take advantage of the upside of a stock but protect gains with a contract that forces a counter-party to buy your position at a predetermined price if the market turns and prices start to go down.
In the past I’ve implemented this strategy through the Powershares S&P 500 Buy/Write Portfolio ETF (PBP, annual cost of 0.75%). In a ‘buy/write’ strategy an investor gets an income boost, captures any stock dividend, and is protected if the market prices reverse.
As good as PBP has been, I’ve migrated to using other vehicles that have had better results. Now, the MarketFlex Hedge portfolio is a combination of two investments: Eaton Vance Tax-Managed Buy-Write Closed-End Fund (ETV, annual cost of 1%) and Horizons NASDAQ 100 Covered Call (QYLD, annual cost of 0.6%).
Between these two, I can hedge the common stocks that make up the bulk of the S&P 500 or NASDAQ 100. According to my data service (Kwanti.com), these are the returns and yield over the YTD through 10-year periods as of 10/27/2017.
While right now I’ve been using this as an income booster, I’m expecting that the real value may be when the market has a correction.
If you’d like an objective second opinion about your finances, please reach out to Steve Stanganelli, CFP®, CRPC®, AEP® at Clear View Wealth Advisors, LLC. Email him at Steve@ClearViewWealthAdvisors.com.