) -- Given the wild ride investors have faced since 2007, many are searching for ways to mitigate risk and keep volatile market forces from wreaking havoc on their finances.
Many such strategies have typically been either stunningly complex or locked within the domain of billionaires and mammoth institutions. Alternative investments (through an endowment-styled approach), forward contracts, swaps, options, derivatives and futures are among the weapons in a hedge fund's arsenal.
You don't need to be a hedge fund or multibillion-dollar institution to protect against market forces.
But what can the average, retail investor do if these options seem either too expensive or complicated?
The first bit of advice offered by Ernie Dawal, chief investment officer for wealth and investment management for
Sun Trust Banks
, is to understand that "average investor" is a misnomer.
"Everyone is going to differ in terms of their financial objective, their tolerance for risk, their desire to avoid taxes and their general knowledge of, or interest in, the financial market," he says. "Some of them are going to want to beat the Joneses; others want to be the Joneses."
Hedging, for most, is really "just a form of insurance," Dawal explains, and like any insurance, "it's important to know what the risks are that individuals need to hedge against or insure against."
"The big risk that everybody always looks at is volatility in the market," Dawal says. "Historically you could count on one hand the number of days where the equity market was going up and down more than 3% or 5%. But back in 2010 and 2011, we had quite a number of those days. So the volatility we see, those swings and fluctuations, are arguably at historical highs."
"The velocity of change has increased dramatically," he adds. "We see price moves happen almost instantaneously and the average Joe or Jane who is sitting there holding individual securities or some other type of portfolio are ill-equipped to respond to those kinds of changes. Maybe that's a good thing, because perhaps they shouldn't be responding."
Instead, Dawal encourages a portfolio that is well-diversified, well-managed and built to weather such volatility. They key is to have assets that are not correlated over an extended period of time.
He sees a diversified portfolio as one that includes cash, bonds and "equities of all ilk -- growth, value and core; large-, mid- and small-cap; international and emerging markets."
"We would also recommend real assets, commodities, real estate, infrastructure, perhaps timber, managed futures, private equity and traditional alternatives," he adds. Ownership isn't enough; there needs to be a strategy for how these assets are used in a portfolio.
In the not-so-distant past, these strategies were out of reach for all but the most high-net-worth investors and institutions. Now many of those hedge fund-worthy strategies have been replicated for a more mainstream audience through mutual funds and ETFs.
"The accessibility has never been greater," Dawal says. "You could argue that some are better than others in delivering on their value proposition, but I think the average investor is in a better position today, with a lot lower amount of capital required, to match these strategies."
To hedge against "credit risk," he says, a diversified portfolio should include "a mix of U.S. Treasuries, rolled up with emerging market or sovereign debt, and corporate debt. These are some multinational global corporations now that have arguably a stronger and larger balance sheet than many of the countries people used to buy sovereign debt from. Think out of the box. How does the average investor access these things? It is probably going to be through a managed or passive fund, or an ETF or something of that nature. Preferred equities are also an option, although the ones we would recommend are a shrinking list."
Risk of return
Not generating enough return over time to meet their goals is a fear of many investors.
"What we've been seeing in the industry is that advisers and wealth managers are focusing less on beating a benchmark as opposed to seeing if your investment portfolio or plan is generating the types of returns that will meet your longer-term objectives," Dawal says. "I think that it starts by having a realistic expectation-setting session with a client. You also have to tell a client that they need to be prepared to take some measured risks. I say 'measured' because I'd avoid fads and making large bets on a single asset type or investment, or what the recommendation on the golf course was. You do need to be rewarded for the amount of risk you are taking."
A "common sense" approach can, in itself, provide an effective protection strategy.
"You need to know what you own and how it is expected to perform," Dawal says. "Don't try to time the market, and stick to the plan ... Investors are always experiencing either buyer's remorse or the opposite, but time and propensity of things to revert to the mean tend to work in the investors favor. If things are going in one direction and you act rashly, you fall victim to what some folks call proximity bias. You base your immediate actions on the recent past or most recent experience, and that usually is a recipe for disaster."
In building a comprehensive financial plan, investors need to also consider longevity risk and insurance of a more literal kind -- life, long-term care -- as well as fixed and variable-rate annuities for post-retirement income protection.
Real estate and commodities can offer protection against inflation.
How you leverage equities can also be a strategic building block, and Dawal advises clients to seek out companies that have sound fundamentals, good balance sheets and solid business models; they can serve as a partial edge against inflationary risk because they can pass their prices along.
A lack of liquidity can lead to the unlucky plight of those who either cannot sell a holding or are forced to do so at a distressed price.
As simple as it may sound, Dawal views having a "rainy-day fund" as another effective hedge strategy. Several months of living expenses held as in emergency funds and liquid investments will protect against a market disaster.
"You should probably hold some of your portfolio in highly liquid securities, for example short-maturity Treasuries and that sort of thing, so you can get access to it and not be subjected to the volatility at the longer end of the curve," Dawal says.
"Institutional and hedge funds can get into the same trap of being in illiquid investments when they need the cash most everybody is trying to sell," he adds. "If you just had that buffer, that cash cushion and the ability to withstand that near-term precipitous decline, then you can participate in the reversion of the mean theory as time kicks in and you are none the worse for it. In fact, you may be better off because you can then selectively sell and take advantage of tax-loss harvesting and repositioning that money."
While the process of selecting a specific ETF or mutual fund as part of a strategy to hedge against market risks has been made relatively straightforward for investors, they can't afford to ignore what lies under the hood of those complex instruments.
"Before investing in any product or security, you really owe it to yourself to understand the ins and outs and nuts and bolts of what you are investing in," advises Paul Jacobs, a certified financial planner with wealth-advisory firm
Palisades Hudson Financial Group's
Atlanta office. "Some products and securities are a lot less complicated than others. Just looking at performance or a track record is not sufficient in and of itself to make a decision. Any investor should really understand how hedging works, how it could work and how it might not work."
For example, Jacobs and his firm had been looking for alternative ways to generate returns.
"We are concerned about bonds," he explains. "We think that with interest rates being this low there's nowhere to go but up. In the past, bonds were a way to reduce volatility in your portfolio and to generate income. Going forward it's a lot easier to envision bonds having negative rates of return. As interest rates go up, bonds are going to go down. So we've been looking for other strategies and investments that can generate similar returns to what you hope to get from bonds but that are not actually bonds."
Jacobs and his colleagues ended up screening more than 600 mutual funds and ETFs that use various hedging strategies in their quest to reduce portfolio volatility without bonds. Requiring three years of results cut down the field by more than half. High management expenses, up to 4% annually, ruled out many others. Also not making the cut were funds that short large-cap U.S. stocks and funds that "depend on an investment 'rock star,' because a star manager may leave or during a downtown suddenly become less brilliant than he seemed."
Performance mattered and several alternative funds were dismissed because they "even managed the difficult feat of losing money in both 2009 and 2010."
Palisades Hudson's investment committee eventually settled on
, a mutual fund that has had positive returns in all but two of the past 15 years (including a 2% drop in 2008). It uses a merger-arbitrage strategy, buying the stocks of acquisition targets and sometimes shorting the acquirer's stock. When deals close, the fund makes money. To prevent losses when deals fail, it hedges risk by using put options and other derivatives.
Palisades Hudson -- a fee-only financial planning firm with $1 billion under management -- replaced 5% to 10% of its clients' fixed-income portfolios with Merger Fund. It added
JPMorgan Tax Aware Real Return Fund
, a muni bond fund that aims to protect against inflation by buying inflation swaps with a portion of the income. To do that, it recently sold its clients' holdings in Treasury Income-Protected Securities.
Ten-year TIPS gained 15.72% last year, but they tend to trade like conventional Treasuries when interest rates are falling, leading Jacobs and his colleagues to believe it was time to reap the profits and move on.
-- Written by Joe Mont in Boston.
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