How to Protect Yourself From the Selloff

Most portfolios have taken hits over the past five weeks.

The S&P 500 Index was down 3.1% in May and was down an additional 0.5% thus far in June.

And many individual stocks and actively managed equity funds have sustained even bigger declines because of the recent selloffs.

Can you expect additional corrections this year? More importantly, how can you defend yourself from this kind of volatility?

If you have not already done so, be sure to include "dividend indices" and "value indices" in your portfolio.

In fact, this may be a good time to buy these specialized indices. They make excellent additions to your portfolio in volatile times.

A "dividend index" is an index of the 50 to 100 highest dividend-yielding stocks.

A "value index" is essentially a basket of equities having lower-than-average prices as determined by their price-to-book and price-to-earnings ratios.

"Value" stocks are deemed to be reasonably priced vis-a-vis real earnings.

By comparison, "growth" stocks trade at higher multiples to earnings.

Although value stocks and value indices focus on attractive pricing relative to actual earnings being achieved now, growth stocks and growth indices focus on "future potential."

Here is a picture of how several different index funds and exchange-traded funds have fared thus far in 2006.

Ports in a Storm
Value and dividend indexes hold up better in down markets.
Symbol Fund or ETF Performance
1 Month YTD 12 Months 3 Years Annualized
vfinx Vanguard 500 Index -4.48% 2.02% 7.38% 10.37%
fsmkx Fidelity Spartan 500 Index -4.47% 2.06% 7.47% 10.41%
vtsmx Vanguard Total Stock Market Index -5.08% 2.45% 9.03% 12.06%
dvy iShares Dow Jones Dividend Index -2.34% 3.94% 5.65% NA
vivax Vanguard Value Index Fund -3.39% 5.24% 11.69% 14.15%
Source: Morningstar.com

All of these index funds sustained losses over the last thirty days -- corrections in the range of 2% to 5%. But the indices focused on dividend payers and/or value stocks had lower corrections. In fact, the iShares Dow Jones Dividend Index ( DVY) actually had positive trailing one-month results as of Friday's close. Both the dividend and value indices -- DVY and ( VIVAX) Vanguard Value Index fund -- have also produced higher year-to-date returns and higher annualized three-year returns than conventional index funds.

Clearly, investing for value and dividends is not failsafe: Each of these indices incurred significant losses -- at least 20% -- in 2002 when the stock market underwent a massive correction. But this investing style has long-term performance advantages.

According to Standard & Poor's, the shares of companies that do not pay dividends in the S&P 500 were down 4.67% during the month of May. The stocks of companies that do pay dividends, however, were down 2.37% during the same period. That's a substantial difference. Lesson one: It's better to hold dividend-payers and intrinsic value.

There is also substantial academic research confirming that equity indices tend to outperform actively-managed funds over the long term. Research by Wharton Professor Jeremy Siegel and investment guru Rob Arnott shows that indices of stocks with low price-to-earnings ratios and/or high dividends produce even higher returns than conventional indices.

Arnott specifically found that while conventional indices produced an average "geometric" return of 10.35% between 1962 and 2004, indices structured on the basis of dividends, book value, or even sales -- among other kinds of index weightings -- performed substantially better. Over a long period of time, in fact, the specialized or "alternative" indices constructed on the basis of dividends or superior price-to-earnings produced returns that were more than 2% per annum better on average than conventional index performance. And conventional indices, I must reiterate, performed better than 75% to 80% of all actively managed equity funds.

Bottom line: Indices of dividend-paying stocks and of "value" stocks often do a better job of shielding you from market volatility, and they deliver superior long-term returns. When you focus on dividends and "fundamental value" rather than capital gains or speculative expectations, you sustain less pain when the market corrects. That was the clear case in May and year-to-date-June.

And it's an important lesson worth remembering going forward because there is still some fat built into prevailing stock prices. The stock market's historic price-to-earnings ratio has been 14.6 to 15 vs. the current P/E of 17 to 18. Since the P/E will revert to its historic mean, additional corrections are likely. Count on it, and prepare for it.

Sharpen Your Focus

When considering these funds, give heavy consideration to the so-called Sharpe Ratio, which measures the incremental return you achieve from a particular investment for each incremental unit of risk. It is computed by isolating the risk component of a particular investment's return (and you do that by subtracting the "risk-free return" of a Treasury bill from the return of the investment under study), then dividing the balance by the investment's volatility or "standard deviation."

A higher Sharpe Ratio is more attractive than a low one. A higher Sharpe Ratio means the investment is giving you better returns on the volatility or price fluctuations you incur. Or put another way, a higher Sharpe Ratio means you're getting more return for the risk. And the above comparison shows that Vanguard's Value Index is delivering better risk returns relative to the other indices.

In addition to the funds mentioned above, there are other value and dividend indices to consider, including exchange-traded funds such as iShares Russell 3000 Value Index ( IWW), iShares Morningstar Large Value Index ( JKF), iShares S&P 500 Value Index ( IVE), and a host of dividend-weighted indices as well.

Jim Schlagheck is a wealth management professional who has counseled ultra-high-net-worth families, endowments and pension funds in the U.S., Europe, and the Middle East. He is a former senior executive of American Express Bank, UBS AG, Bank Julius Baer, and TAIB Bank. During his career, Schlagheck launched a family of mutual funds (now holding $4 billion), led teams of financial planners and investment advisers based in New York, Bahrain, and Geneva, Switzerland, and helped many high-profile clients to protect and enlarge their wealth. Jim has a blog on investment topics www.invest-blog.com and is the author of "Show Me The Money!", a soon-to-be-published book that synthesizes his novel views about investing for retirement.

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