Protecting Your Portfolio from the Next Market Downturn

Even though many funds have recovered the same percentage they lost since March 2009, they still have a long way to go before their investors are made whole. Simple arithmetic says that when you lose half of your money, you must double it (that is, earn a 100% return) to break even. That recovery can take a long time. The stock market's last crash, between March 2000 and October 2002, was milder, with the S&P 500 Index losing 47%. But it took more than four years, until October 2006, to recover, only to experience another, more severe crash a year later. Some of us can't afford to wait that long to recover, especially those who are already retired.

The Alternatives Alternative
Clearly, protecting your portfolio is important. Although a simple portfolio can be effective over the long haul, there are other diversification options, such as mutual funds that practice "alternative" strategies, many of which fall in Morningstar's long-short category. These funds use different trading strategies, such as hedging or arbitrage, or different asset classes, such as commodity futures, options, and currencies--all with one goal in mind: to have low correlations (usually) with the stock market. That is, the market's ups and downs should not highly correspond with the funds' vacillations. In good times for the stock market, these funds may post small losses, stay flat, or gain less than equities. In bad times, these funds should either gain ground or lose substantially less than the market. An allocation to these types of funds could thus reduce or negate the overall losses to a standard stock and bond portfolio, making it easier to start rebuilding your wealth.

Of course, not all alternative funds are created equal, and alternative funds vary even more widely in strategy and performance than other mutual fund groups. Therefore, we looked at all 49 funds in Morningstar's long-short category with inception dates prior to the October 2007 crash to answer a couple of questions. First, did these funds help investors diversify overall? Second, which funds did the best job?

The average long-short mutual fund lost 19.1% between early October 2007 and early March 2009. That's less than half the S&P 500's losses. The average long-short fund has recovered 16.5% through Sept. 15, 2009, but still has 20.8% left to break even. Even more interesting, however, is the range of returns that alternative funds posted during the market crash. JPMorgan Intrepid Plus lost the most, 56%, while  Rydex Managed Futures Strategy gained the most, 18%. At the risk of stating the obvious, these two funds are very different from each other, as are many of the funds in the long-short category. The JPMorgan fund takes long and short bets on equities, while the Rydex fund takes directional long and short positions in commodity and financial futures. Because of their strategies, JPMorgan Intrepid Plus will act more like the stock market, whereas Rydex Managed Futures Strategy will generally not, making it a better diversifier.

The funds that could help diversify investors' portfolios the most are those that lost the least and preserved wealth. There are 14 such long-short funds--funds that never lost money in the first place, or funds that lost some but have recovered nicely in just six months time. These 14 funds averaged only a 2% drop, much less than the rest of the category.

 
While recent history on these funds provides some comfort, we also looked at their behavior in the last bear market. Six of these 14 alternative funds existed then:  Robeco Long/Short Equity , JPMorgan Market Neutral ,  Caldwell & Orkin Market Opportunity , Virtus Market Neutral , GMO Alpha Only III , and  Merger Fund . All posted positive returns during the tech bubble's bursting, and all but one fund (Virtus Market Neutral) sport 4-and 5-star Morningstar Ratings.

So much for the past. Here's our short list of alternative funds for the future.

 Highbridge Statistical Market Neutral
If protecting your downside risk, rather than participating in the market's recovery, is of utmost importance, you should consider a fund with a market neutral equity or arbitrage strategy. Highbridge Statistical Market Neutral quantitatively trades equities long and short, but does so in a manner that the equity market risk of the long stocks in the portfolio is completely offset by the short stocks. What you're left with is the return from stock-picking skills, which the fund has demonstrated. This fund has returned 3.44% since its late-2005  inception (through Sept. 15) with a zero-correlation to the S&P 500.

JP Morgan Market Neutral
This fund is also market neutral, but unlike Highbridge, it relies less on computer-driven statistical models and more on management's fundamentally based decisions. This fund exhibits a low correlation to the S&P 500, less than 0.2 since inception more than 10 years ago, and has returned 3.45% annualized over that time period. Its net expense ratio, though, is substantively less than that of Highbridge, which makes it more attractive to some investors.

 Merger
Merger Fund also hedges out equity market risk by taking long and short positions in stocks, but it specializes in stocks involved in mergers and acquisitions. Simply, it buys the acquiree and shorts the acquisitor, in an effort to capture the premium an acquisitor pays for its target. The strategy is not loss-proof, however. These "arbitrage" trades fall apart when announced deals do. But the losses tend to be small, as in the market neutral equity funds. Unlike many "alternative" funds, this fund has a 20-year track record, returning 7.5% annualized over its life, with a 0.4 correlation to the S&P 500.

 Arbitrage
Arbritrage Fund uses the same approach that Merger does, with similar results. Since its inception in 2000, this fund has returned 6% annualized, with a 0.4 correlation, but it has outperformed the Merger Fund in recent years. Because it's much smaller, it's able to better take advantage of smaller-cap deals, which may be advantageous in environments where merger deals are smaller and less frequent. This fund's expense ratio, however, is dearer than the Merger Fund's.

 Rydex/SGI Managed Futures Strategy
This fund offers one of the newest and most unique ways to diversify a portfolio. This fund tracks the S&P Diversified Trend Indicator and profits from both positive and negative trends (a form of momentum) in a diverse basket of futures markets--both financial futures such as equity index futures and commodity futures such as metals or agriculture. When the various futures markets lack up and down trends, this fund can lose money, but the beauty of this strategy is that it truly diversifies a standard stock and bond portfolio by trading a different type of risk (momentum) in various assets. Although the fund is relatively new, the indicator has been around since 2003 and sports a 7% annualized return since inception with a slightly negative correlation to the S&P 500.

If there's one thing that the recent bear market has taught us, it's that even broad, diversified portfolios can be vulnerable. Using alternatives funds is one way to limit losses. When looking at an alternative fund for diversification, though, be sure to look at a fund's returns during periods of market turmoil. It can be the fund's most-telling statistic.