Best Bets if a Correction Comes 

By Bob Plunkett 

Last April, Forbes magazine warned its readers to start looking for ways to protect their portfolio from a potential 27% or more drop in stocks. That hasn’t happened, but the warnings continue to pile up.  

Historically, worried investors have looked to bonds. But with interest rates still at historical lows, bonds aren’t the safe investment they used to be. The Federal Reserve is raising rates and when that happens, existing bonds lose their value because new bonds can yield more.  

Worse, the Fed is expected to start selling off all those bonds it bought to boost the economy after the crisis in 2008. European Central Banks will not be far behind and your bond values could fall even more. So investors have to look beyond bonds as an alternative investment to stocks for protection because they both could be heading toward a sharp drop at the same time. 

The answer to buffering your portfolio against losses is simple, but not easy. You want alternative investments that are completely uncorrelated to your current portfolio so that they behave as differently as possible. Fair enough – but.  

You must remember, selecting the right alternative mix for your portfolio doesn’t reduce risk in general but rather reduces exposure to certain risk factors. And the risk factor you need to guard against depends upon what assets you are trying to protect. Simply put, what assets you are looking to protect against will dictate which alternative investment you use. 

You may not believe this but to protect against rising rates and higher inflation, real estate may be your best insurance policy. Both property values as well as rents tend to increase faster during periods of rising inflation. Publicly traded real estate investment trusts (REIT) have outpaced inflation every year between 1974 and 2011. 

In addition to REITs, investors can add real estate to their holdings through private equity or direct ownership in properties. The problem with investing directly in real estate is that your money is often tied up for a long duration. The alternative is to invest in real estate debt. To determine if this is for you, consider this first principle of investing in commercial real estate debt such as one-to-three-year bridge loans: investors can use the short duration to hedge against interest rate risk – you’re not locked in for five or 10 years if rates rise – and the underlying collateral to protect against principal losses. Got that? if not, this is not for you and stick with considering REITs. 

Investment experts will show you research showing of private equity mutual funds. They have outperformed public equity and have lower volatility over a long period. This is mostly because there isn’t a daily market for private equity, so investors can’t always sell their investments when they want to. In return they earn a “liquidity premium” in exchange for forgoing access to the funds. That restricted access prevents investors from panic-selling, which frees the investment manager from having to keep cash on hand for unplanned redemptions. 

Private equity often requires a high minimum investment, typically between $100,000 and $250,000, although some private equity mutual funds have lower minimums. Private equity mutual funds carry high expenses ratios often above 2 percent.  

Then there are hedge funds. The attraction is they can have a short position in the market and so tend to increase in value during market downturns (just like you would if you shorted stock). However, they don’t typically do well during bull markets, so investors may only want a small piece of their portfolio dedicated to hedge funds. With any style of hedge fund, keep in mind that the fund’s success is closely tied to the skill of the fund manager. As with private equity, hedge funds can be highly illiquid. 

You could also invest in futures contracts as opposed to securities. These managers are allowed to diversify across a wide array of investments like equity indices, fixed income, currencies and commodities. They can take long or short positions with any assets and make moves quickly in a volatile market. During the financial crisis of 2008, managed futures averaged 15% to 20% gains while the average stock portfolio was down 50%. 

Finally there are annuities. You usually don’t categorize an annuity as an alternative investment but they do give you a clear, definite reduction in risk and a definitive guarantee return should something happen in the market. The annuity allows you to participate in potential market growth without investing directly in the market. But the downside protection comes at a cost in the form of a cap on upside potential, so that no matter how well the index performs, your return will never exceed the cap. But if you want protection from a market downturn without completely sacrificing market participation, index annuities may be the lowest risk strategy.