Downside Portfolio Protection

The Street featured an article titled “Simple Ideas for Downside Portfolio Protection.”

As I read it, I got the distinct feeling that there was not much conviction behind the suggestions.

I have seen similar articles with the same topic before, and they all appear to say “yes, you can do these things, but…” And the big “but” is this: “While you will lose less money in a bear market implementing these suggestions, you will miss out on most of the upside when the market recovers.”

As if that is the worst thing that could happen to you. I wonder if any of these writers ever put a pencil to the task and analyze if what they are saying really makes sense.

Let’s look at the 3 examples from the above article, and I will calculate the numbers for you. You will be amazed at the outcome:

The market meltdown of 2008-09 is seared into investor’s memories — the S&P 500 dropped 37% in 2008, after all — but there is a simple and cost-effective way to avoid the full brunt of equity market downturns: Look for dividend-focused exchange traded funds.

Be careful, though. They are not all created equal. Some funds may be overweighted toward sectors such as utilities or financial services, while I prefer a fund such as Vanguard Dividend Appreciation (VIG), which typically yields a bit more than the S&P 500 but is also focused on high-quality, dividend-paying companies. (Another plus for this ETF is its small expense ratio of 0.20%. During 2008 this fund declined by 26.7%, roughly 72% of the S&P 500’s decline. During 2009, VIG rose only 19.6% versus 26.5% for the S&P 500. So, yes, there is a tradeoff in rising markets — this fund provides less upside. In fact, it captured just 74% of the S&P 500’s return. Still, for someone more interested in downside protection, that is not a bad deal.)

OK, let’s look at some numbers assuming you had $100,000 to invest. In 2008, VIG lost 26.7% bringing your balance down to $73,300. In 2009, VIG gained 19.6%, which increased your balance back to $87,667.

Compare this to the benchmark S&P 500. It lost 37% in 2008 reducing your balance to $63,000. In 2009, it gained 26.5% bringing your balance back up to $79,695.

The investment management industry also offers mutual funds with alternative strategies designed to protect investors. Most of these products come with higher management fees due to the nature of the investment strategy.

So what are some of these strategies? Long/short and market-neutral are two strategies now available as mutual funds. Long/short funds invest in equities by going long in some stocks while shorting other stocks. Some of the mutual funds in this category do not actually short individual stocks, but use options to hedge their long equity positions. The strategy of a market-neutral fund is to provide a positive return regardless of equity market conditions. Morningstar (MORN) has even broken these two strategies out into their own fund categories this year.

How did these funds perform in 2008? The Morningstar category average for long/short funds was -15.4%. Based on the category average, these funds captured only 41.6% of the downside. During 2009 the category average for long/short funds was 10.5% versus 26.5% for the S&P 500. In essence, the long/short category average captured roughly 40% of the upside.

Let’s use the same math for these Long/Short funds. In 2008, your $100,000 portfolio would have been reduced by 15.4% to $84,600. In 2009, your gain of 10.5% brought your balance up to $93,483.

For comparison, the S&P’s balance for the same period ended up being $79,695.

Next let’s review how market-neutral funds performed during 2008: -0.33% in the Morningstar category average, significantly better than the S&P 500’s performance of -37% — in fact, almost in striking distance of break-even. In the next year, though, the market-neutral category average was negative -1.18% during a rapidly rising market, capturing nowhere near the upside of the market.

Using dividend funds and alternative strategies can provide downside portfolio protection for investors. But investors need to remember the tradeoff: giving up some of the market upside.

[Emphasis added]

Let’s look at the facts again. Your $100,000 portfolio dropped by 0.33% in 2008 reducing its value to $99,670. In 2009, you again lost 1.18% bringing your value down to $98,494.

Again, the S&P 500 ended up after the same period with $79,695.

Hmm, which result do you prefer?

These are 3 examples I did not make up, which clearly describe the idiocy and misinformation of it all. Who cares if you miss out on the upside; it’s far more important to avoid going down in a severe bear market such as 2008.

It amazes me how many investors are simply ignorant and do not understand simple math. If you lose 50% of your portfolio, you have to make 100% on the balance just to get back to even. The above article clearly demonstrates that your emphasis should be on bear market avoidance and not trying to catch every up move in the market place.

To my way of thinking, the entire article is faulty to begin with, in that there is no method described that you can apply to shift gears and move into the conservative mode described above; it’s nothing but a wild guessing game.

Of course, I am biased, but I believe that you will be far better off following the major trends in the market. Get out of equities when a major trend reversal takes place, which you can easily identify with my Trend Tracking Indexes.

Along the way, use trailing sell stops, as I advocate, and you have a definitive plan in place that allows you to better deal with the uncertainties of the market place.

Disclosure: No holdings

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