NEW YORK ( TheStreet) -- Since May 9, 2009, I have suggested that investors bet against the dollar by purchasing mutual funds and exchange traded funds in Africa, Latin America and Asia. As I reported in a recent article, these investments have done well:

Was I lucky? I don't like to think so: I made strong economic arguments for these investments. And even with their price run ups, I plan to stick with them. Why? Because I believe these regions will be the growth engines of the 21st century and the dollar will weaken further.

Long positions:

But there is one thing that bothers me: I have long positions in all these investments with no protection. At this point, I would settle for lower returns if I could somehow reduce the downside risk.

What do I know about limiting downside risk? Not much. Sure, I have heard about hedging, puts, calls, etc., but I thought I could learn a lot more by talking to someone who is a real professional at limiting risk.

Matt Lenehan earned an MBA from the Tuck School of Business at Dartmouth. He received the Chartered Alternative Investment Analyst (CAIA) professional designation for "alternative" asset classes, including real estate, private equity and hedge funds. Matt invested endowment funds at Dartmouth before co-founding Newport Investment Management with two partners. Like endowments, Newport worries a lot about downside risk.

Elliott: First, I want your opinion -- do you think I've just been lucky?

Matt: No. As the following table indicates, your holdings compare favorably against a representative basket of broad and BRIC-centric exposure. As compared to a 75%/25% blend of Vanguard Emerging Markets ETF ( VWO) and SPDR S&P BRIC 40 ETF ( BIK), your portfolio has significantly outperformed portfolios with comparable risk. This more than justifies the higher expense of using some active investing by mutual fund managers.

Reducing risk:

Elliott: Why is limiting risk such a focus? And what do you do at Newport to limit risks?

Matt: Endowments got hit hard by losses resulting from the U.S. banking collapse. Investments with equity exposure, whether publicly traded or through private partnerships, contributed to 19% average endowment losses for the year ended June 2009 (Per 2009 NACUBO-Commonfund Study of Endowments Top endowments like Harvard and Yale lost 25%-plus. As a result, many boards revisited risk and now see that allocations to hedge funds, which can short and still lost 12% in the same year, are not enough.

In establishing Newport, we made risk control -- taking systematic action to limit losses from falling equities -- a cornerstone of our investment approach. The math is so compelling to focus on loss avoidance when you need a 25% gain in year 2 to make up for a 20% decline in year 1. And the lower or negative correlation of fixed income and alternatives means they should hold value better or even appreciate when equities suffer. In short, we decided we needed to do more to limit downside risk in our investment strategies than just following the endowment model approach of broad asset-class diversification.

Elliott: What concretely do you do to limit risk?

Matt: We take three deliberate actions. As indicated, we allocate roughly 15% to 25% to alternative asset classes, including real estate debt and equity, private equity, infrastructure, commodities and energy partnerships. These collectively have been shown to lower portfolio risk and enhance returns over time. Second, we emphasize high current yield to improve the quality of return through less reliance on appreciation. With the 10-year Treasury at 2.6%, we love positions with 5%-plus dividend rates, particularly when they also offer more appreciation than those lower in the capital structure like debt.

Third and most importantly, we try to hedge downside by moving riskier equities to cash during market downtrends. Technical indicators such as volatility and trading volume can effectively be used to gauge, but not predict, the current trend of broad equity categories such as large caps or the Nasdaq. This information can be a powerful tool in helping us to avoid losses directly by moving to cash or indirectly by trading small caps for large-cap U.S. value. Like any good resource, we use research with long and strong track records to invest up to 20% of our strategies in cash. In general, we've found that quantitative research provides a useful complement to a fundamental investment approach. And when it comes to performance, we're agnostic to its sources and have found that quantitative research provides a useful complement to a fundamental investment approach.

Elliott: By moving to cash, do you mean trying to time the market?

Matt: Yes and no. Yes, in the sense that there's a timing aspect to all investing. This year we've liked emerging market equities, high-yield debt and master limited partnerships, but our views will necessarily change with market conditions and time. The zero percent return on equities for the past decade suggests that we should time markets rather than simply buy and hold.

No, in the sense that we've become convinced that even basic trend analysis can add meaningful alpha to a portfolio over time by helping us to avoid losses -- Warren Buffett's Rule No. 1. Ned Davis ran a study from 1979 to 2007 that showed that using a simple 200-day moving average strategy to invest in equities or cash yielded higher returns than holding the S&P 500, and with less risk. (Ned Davis as reported by, May 10, 2007: While we use a more refined approach, such data are compelling and give us the confidence to replace a portion of riskier equities with cash. For example, during the flash crash of May 6, we significantly cut back our small-cap exposure -- about 8% above the market's July bottom.

Elliott: I look at my situation -- I like my investments but I want to reduce downside risk. What would you suggest?

Matt: More than any other sector, the emerging markets embody risk and reward. Following the global market trough, your picks clearly illustrate reward and trying to reduce the risk of emerging markets exposure makes sense. Of the three primary risks they pose -- currency, political/ regulatory and economic -- only currency can be directly "hedged." However, the cost of hedging specific-country and broad basket currency exposure is often too high to justify. Also, many investors want naked exposure abroad, given the falling U.S. dollar.

Elliott: Yes, I want naked exposure. I want to bet that the dollar will fall.

Matt: As a global economist who has worked in 40-odd emerging nations, you're better positioned than most investors to draw on first-hand knowledge to evaluate political/regulatory risks. That said, you've also opted for the local insight and expertise of active mutual fund managers and it has enhanced your portfolio's returns. In contrast, we typically invest through indexed securities governed by the SEC, but there's no real way to guard against foreign-government intervention or fraud.

Elliott: And how do you hedge entire economies/markets?

Matt: We've used bonds ( iShares JP Morgan USD Emerging Market Bond ETF ( EMB)) and infrastructure ( PowerShares Emerging Markets Infrastructure Portfolio ETF ( PXR)) to somewhat damp the extreme volatility that characterizes emerging market equities. But we are reluctant to short securities: Shorting is both costly and extraordinarily risky in the case of emerging markets. Rather, we see three practical ways for investors to lower the risk in portfolios like yours.

First, you might consider holding a small position in securities like S&P 500 Volatility ( VIX) that tends to appreciate when markets become more volatile. In effect, VIX becomes catastrophic insurance against another crisis.

Second, take a small short position in commodities. Some investors see markets like Brazil and Russia as being interlinked with global oil prices, for example. Therefore, you might consider being short oil futures ( PowerShares DB Crude Oil Short ETN ( SZO)) to counter the possibility that emerging economies suddenly cool. While we don't like leverage, you can get broad short exposure through double inverse securities like ProShares UltraShort DJ-UBS Commodity ETF ( CMD) and PowerShares DB Commodity Double Short ETN ( DEE). As an exchange traded note, DEE addresses tracking error concerns but carries credit risk. Unlike directly shorting securities, you can't lose more than your investment in such inverse securities.

Lastly, over a longer time frame, you might develop the means to identify market weakness and use cash as a tactical asset class. We expect trends to reverse several times a year, and we've converted as much as a third of our overall equity exposure to cash in periods like May. As volatility increases, our clients appreciate being in cash but we don't go there based on intuition and it's never more than a temporary hold. Since equity markets tend to trend in an upward sloping direction over time, the only thing that trumps appreciation is preservation.

For more information on Newport Investment Management, see the Web site or message

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Elliott Morss is an economic consultant and an individual investor in developing countries. He has taught at the University of Michigan, Harvard University, Boston University, among other schools. Morss worked at the International Monetary Fund and helped establish Development Alternatives Inc. He has co-written six books and published more than four dozen articles in professional journals.

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