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Options for Market Correction Protection

As many industry experts predict an end to our eight-year bull market, many investors are beginning to consider ways to protect their portfolio from the looming drop in stocks. Bonds have been a go-to in years past, but as interest rates remain low, many are looking elsewhere. As interest rates rise, which they are expected to, the prices of bonds fall in order to make up for their lower yields.

Meanwhile, the Federal Reserve could potentially put more pressure on bond prices. When the financial crisis hit, the Fed bought several bonds to shore up the credit market, bloating its balance sheet. The same balance sheet that the Fed is expected to start shrinking some time in September.

“What happens to all rates if the biggest yield-agnostic buyers are no longer in market, much less shrinking their balance sheet?” asked Andrew Cowen, a portfolio manager of Community Capital Management’s Alternative Income Fund in a recent U.S.News article.

Many industry experts believe that the answer may be alternative protective  investments, as stocks and bonds may be headed for a drop at the same time. The key is for your alternative investments to be uncorrelated to your traditional portfolio so they behave differently. As stock and bond markets drop, your alternatives should remain unaffected, or even rise. When looking for the right alternative, however, consider that they may not reduce risk in general, but instead reduce exposure to whichever risk you’re trying to avoid. Here’s a look at some alternative options that may work for your unique situation.

To buffer against rising inflation and interest rates

Real estate might be your best bet in this scenario. “Both property values as well as rents tend to increase faster during period of rising inflation,” said Deepak Tayal, the former head of risk for Alternative Investments at Oppenheimer Funds in New York. Between the years 1974 and 2011, publicly traded real estate investment trusts have outpaced inflation. Additionally, private equity or direct ownership in properties is an option, but be aware that your money is often tied up for a long duration here.

The cure for panic-selling

Over the long haul, studies have shown that private equity has outperformed public equity with lower volatility. This may be due to the fact that there isn’t a daily market for private equity, preventing investors from selling when they want to. This reduces “panic-selling” which keeps the investment manager from having to keep cash on hand for unplanned redemptions. The downside might be considered the high minimum investment often associated with private equity, typically between $100,000 and $250,000.

A way to offset a down market

Hedge funds may give investors “the ability to short out market exposure,” according to Adam I. Taback, head of Global Alternative Investments, a division of Wells Fargo Investment Institute in Charlotte, North Carolina. Those with a net short position often increase in value during market downturns, said John Sedunov, an assistant professor of finance at the Villanova University School of Business in Villanova, Pennsylvania. “However, these types of funds don’t typically perform well during bull markets, so investors may only want a small piece of their portfolio dedicated to [them].” Consider volatility-based hedge fund strategies for protection in a bear market, when volatility typically increases. Keep in mind that the fund’s success is closely tied to the skill of the fund manager, and are often highly illiquid.

The solution to concentration risk

In order to diversify across equity indices, fixed income, currencies and commodities, you can invest in future contracts/managed futures as opposed to securities. “They can gtake long or short positions in any of these asset classes and have shown a particular ability to ‘zig’ when the other markets ‘zag,’” said Matt Osborne, founder and CIO of La Jolla, California-based Altegris Clearing Solutions. During the financial crisis in 2008, managed futures were “typically up 15 to 20%, rather than down 50 like your stock portfolio,” he added. Allocating 5 to 10% of a portfolio to managed futures funds is a common diversification tool.

The lower-risk alternative investment

“You wouldn’t normally categorize an annuity as an alternative,” said Mark Snyder, founder and president of Mark J. Snyder Financial Services, but one exception is the Allianz Index Advantage New York Variable Annuity. “This gives you a clear, definite reduction in risk,” Snyder added, by providing “a definitive guaranteed should something happen in the market.”

Some annuities allow investors to take advantage of potential market growth without investing directly in the market by tying the contract value to the performance of an index, such as the Russell 2000 or the Standard & Poor’s 500. Meanwhile, the insurer guarantees against losses up to a given threshold based on the contract terms. There is, however, a cap on upside potential, meaning regardless of how well the index performs, your return will never exceed the cap. But if you’re looking for protection from market downturns without giving up market participation, index annuities may be the lowest risk strategy.

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