The email I get from readers indicates there's a keen interest in achieving returns that roughly equal the market but that take less risk and have an increased yield. The interest in this concept seems heightened now that the market has gone almost straight up for several months.

I believe there is a lot of value in exploring how to structure portfolios to create a desired effect. This can go a long way toward learning more about how capital markets work, which in turn can lead to better returns or, more specifically, better risk-adjusted returns.

Let me explain "risk-adjusted returns." Say the market goes up 10% in a year, and a given portfolio goes up only 8.5% in that same year -- but does so by taking on only half of the risk of the market. So that portfolio's result, while not market-beating at first blush, is actually a very good result.

After the big market run we've enjoyed lately, it makes sense to be concerned that there is a high probability the market could correct or trade sideways. In this column, I'll explore how to make a couple of changes to an existing portfolio in an effort to reduce volatility and correlation to the market without making a big bet, in case the market defies history and keeps going up at the same rate.

Start with the assumption that an equity portfolio for a U.S.-based investor is 75% domestic (in Spyders ( SPY)) and 25% foreign (in iShares MSCI EAFE ( EFA)). To reduce volatility and correlation but still capture most of a big move up, let's cut the Spyders weight to 50% and reallocate that 25% of the capital in 5% increments to:
  • Calamos Convertible Opportunities and Income Fund (CHI): A convertible bond fund that yields 9%. Convertibles tend to be less sensitive to interest rates because the bonds can convert into common stock.
  • PowerShares DB Currency Harvest Fund (DBV): Goes long the three highest-yielding currencies in the Group of 10 and short the three lowest-yielding currencies in a carry trade of sorts, as I've written .
  • CurrencyShares British Pound Sterling Trust (FXB): This very small fund (averages just under 7,000 shares daily and a market cap that doesn't quite make $60 million) simply owns British pounds and goes up when the pound goes up against the U.S. dollar (and down in the reverse case).
  • Alpine Global Dynamic Dividend Fund (AGD): A closed-end fund that makes use of the dividend-capture strategy .
  • BlackRock Enhanced Equity Yield Fund (EEF): A call-writing closed-end fund that appears to be a little less volatile than other funds that use the same general strategy.

Before I deconstruct this mix, note the most important thing about these five products: All rely on different strategies to achieve their respective results.

An important element of diversification is not being overly exposed (that is, too vulnerable) to one type of trade going bad. For example, EEF is a call-writing closed-end fund. I am a huge fan of the concept, but in practice don't allocate even 5% to the theme. Or if something bad were to happen to the dividend-capture strategy that AGD is based on, there shouldn't be any lasting impact on the other products in our imagined portfolio -- and therefore the whole portfolio.

Reallocated Portfolio
Low correlation to S&P
Ticker Beta Correlation to SPX
AGD 0.58 0.39
CHI 0.16 0.21
DBV 0.34 0.48
EEF 0.49 0.31
FXB 0.09 0.14

I ran this reallocated portfolio through to check its beta and correlation to the S&P 500. Our moderately defensive mix has a beta of 0.86 and a correlation to the S&P 500 of 0.94. It also yields 3.13%, compared with 1.7% for the SPX.

So on the surface, the combined entity doesn't seem much different from our original mix. But drill down to check out the stats on each of the five new additions. Taken separately, each has a very low correlation to the S&P 500 and a very low beta.

Remember, the goal here is to reduce the impact of a market correction on a portfolio, not to time a correction. I believe that introducing components like the ones studied here can reduce a portfolio's overall volatility during a downturn.

The chart below shows how all of the above funds reacted during the stress test of the first quarter of this year. (Remember that late-February dip? I thought so.) All but AGD held up better than the original two components of our portfolio, the S&P 500 and iShares MSCI EAFE Fund.

What's more, I believe that if this market rally continues, most of these funds would capture most of the effect, even if there is a small lag. Any lag could be partially offset by the enhanced yield.

Specifically, I think EEF and AGD would keep up on a total return basis. FXB could remain strong, as currencies go, if demand for the yen carry trade continues to be a catalyst for higher equity prices, but because it's a currency product it's likely to lag stocks. DBV, being a fund built around the carry trade, is also a beneficiary of a weak yen. As a bond fund, CHI is likely to lag on a price basis but its 9% yield will make up a fair bit of the difference.

Good Stress Test
Most portfolio enhancements held up better than the portfolio's original mix during the first quarter
Click here for larger image.
Source: Yahoo! Finance

An investor implementing the above portfolio on the first trading day of the year would have been up 6.58% as of the close on May 25, compared with a return of 7.53% (including dividends) for being 100% invested in Spyders during the same period. I would expect the results to look more favorable once a year's worth of dividends has been paid.

This sort of trade-off is a compelling. Keep in mind that this is just an example, but I hope this serves as springboard for you to develop your own ideas.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider PowerShares DB Currency Harvest Fund, CurrencyShares British Pound Sterling Trust and BlackRock Enhanced Equity Yield Fund to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
At the time of publication, Nusbaum was long Alpine Global Dynamic Dividend Fund and Calamos Convertible Opportunities and Income Fund for client accounts, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.