How Advisers Provide Investors with Downside Protection

From short-term plans to bonds and private equity, advisers share their strategies for building downside risk protection and portfolio diversification.
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More than half of financial advisers indicate that they are very focused on providing clients with downside risk protection and portfolio diversification over the next 12 months, according to recent research.

Fifty-five percent of advisers are “very focused” and 39% are “somewhat focused” on downside risk protection, according to research published by Cerulli Associates in a recent issue of the Investments & Wealth Research report. And, 55% of advisers are “very focused” and 36% are “somewhat focused” on portfolio diversification, for example uncorrelated asset classes, according to the report.

So how are advisers providing clients with downside protection?

Based on an informal survey of advisers, there doesn’t seem to be a consistent strategy or tactic. In fact, the tactics range from the safe to the exotic with some using buckets while others are using covered calls and still others are using private equity and structured notes.

A Bucket for Short-Term Funds

“The concept of liability matching, having safer more liquid funds available to fund retirement paycheck income annually for three to five years, including taxes due, outside the stock market is a prudent philosophy,” said Michelle Buonincontri, a certified financial planner with Being Mindful in Divorce. “That way, investment positions don’t have to be sold to raise cash in the years the stock market is down; helping to reduce investment sequence risk.”

Short-Term Bonds Reduce Interest Rate Risk

Justin Shure, a certified financial planner Endeavor Strategic Wealth, is using short-term bonds to reduce interest rate risk and provide income. As for individual equities, Shure is focused on investing in “quality dividend stocks that have strong earnings and relative strength.”

As for portfolio diversification, Shure is using a tactical approach that looks at the macro factors in the market to determine when to increase cash, gold, bonds, or even ETFs that are short the market for the appropriate client.

Safe Government Bonds

According to Rob Greenman, a certified financial planner with Vista Capital Partners, having a portfolio asset that is maintaining, if not improving, in value during such extreme and difficult periods helps investors avoid one of the biggest, yet most common, mistakes.

What is that mistake? “Giving up on stocks and selling when prices are down,” he said. “No investment has offered this protection better than safe government bonds around the globe, and nothing appears safer today. This is the role bonds should play in portfolio construction.”

Private Equity and Structured Notes

Eric Walters, a certified financial planner with Summit Hill Wealth Management is using multiple tactics to provide downside protection to clients.

One, he’s removed exposure to high yield or credit exposure in the firm’s bond portfolio. “I don't think it is worth the risk at these elevated levels,” he said.

Two, he’s rebalanced away from growth stocks to take profits and adjust equity levels back down to targets.

Three, Walters is using private equity to “access higher returns and avoid the volatility in public markets.”

And four, he’s using structured notes “with enhanced upside and downside protection from equity declines.”

Matt Chancey, a certified financial planner with Dempsey Lord Smith, is also fond of using structured products. “I educated clients on options like structured products with defined risks and those come with lots of different wrappers,” he said.

In addition, he likes ETFs that are hedged.

Private Real Estate Development

As for portfolio diversification, Chancey is using “private real estate development where we create the value of the asset and then sell off those newly constructed assets to REITs.”

This way, he said, “we don't have to wait on the market to provide value since we manufacture it.”

Market-Linked Notes and Buffered ETFs

Thomas Balcom, a certified financial planner with 1650 Wealth Management, reports that about 35% of his clients' portfolios are invested in holdings that offer downside protection.

His approach: “We use customized market-linked notes and buffered ETFs to accomplish this goal.”

This approach allows his clients “to participate in the market while also offering ‘airbags’ and ‘seat belts’ when it hits rough patches,” said Balcom. “While we may not participate in all of the upside, having these strategies in place keeps our clients from selling out during bear markets which would erode their wealth.”

Develop a Comprehensive Plan

Nicole Gopoian Wirick, a certified financial planner with Prosperity Wealth Strategies, says managing risk is an important element of portfolio construction and should be considered in good and bad times alike.

“I believe the best way to manage risk is by developing a comprehensive financial plan that addresses long-, mid- and short-term goals and cash flow requirements,” she says. “Once an appropriate plan is in place, the investment portfolio should be aligned with the objectives of the plan using a globally diversified, multi-asset class portfolio with non-correlated assets.”

The benefit of this type of portfolio, says Gopoian Wirick, is that when one asset zigs, the other should zag, with the goal of experiencing a smoother return over time. “Save bumpy rides for jet skiing and thrills for the amusement park,” she says. “When it comes to your money, be boring and remember you’re in it for the long haul. The ride will be much more enjoyable.”