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Posted by on Sep 3, 2015 in ETF Strategist, Investment Perspective

Defensive Expectations

Defensive Expectations

By Roger Nusbaum, AdvisorShares ETF Strategist

Last week there was an article in the WSJ noting the performance struggles of one of the larger liquid alternative mutual funds. I am not going to link to the article or name the fund because any fund can do very well, attract a lot of assets, then do poorly and lose the assets which is the arc of this fund’s story but instead want to focus on avoid that sort of loop or at least recognizing the potential for that sort of loop so that no one is surprised if/when it happens.

For many years I have been writing about the idea that diversifiers, as I have previously called them, often do not trade like the stock market and so can offer a zigzag effect to equity holdings which can matter during periods like now. There is no guarantee of this of course but just as was the case with the previous bear market some diversifiers will deliver and some will not.

The fund featured in the above mentioned article had problems that included a large bet on China that went poorly and was a drag on returns. One of the fund’s objectives is lower volatility than the broad market yet based on stale holdings reported on Google Finance three of its top ten holdings totaling about 13% were in China. The fund did very well for a time early in the current decade, tracking the equity market closely but started to trail off but still moving higher in 2013 and then starting to go negative in early 2014 and has been in a downtrend for the majority of the time since then.

Obviously if Chinese equities had rocketed higher then some or maybe all of the downturn could have been offset.

This places an important emphasis to not just glance at the holdings but actually understand the pros and cons of any larger exposures. Are there a lot of longer dated bonds in your liquid alternative? If so are you concerned about rising rates, can the fund change that exposure? What about commodity exposures or foreign currency?

None of these are bad but they need to be understood and followed closely. Additionally it is crucial to spend the time understanding what the fund can and cannot do to change exposures and the process behind portfolio changes.

A fund that can make narrow bets on a specific outcome with a large percentage of assets lends itself to being very right or very wrong. Very wrong in a bull market for everything else is probably not a big deal but during a decline like this, then it is unfortunate.

Gold has taken a beating from a sentiment standpoint for how poorly it has performed for the last few years. Throughout, I noted that it was doing exactly what investors should hope; looking nothing like the equity market which created the reasonable expectation of not looking like equities in a downturn and that is how it has played out over the last month as the S&P 500 is down mid-single digits and gold is up mid-single digits. It is not a perfect, negative correlation but has helped.

The bigger context with a post like this has always been to try to soften the blow of a large decline not completely miss it (completely missing it would be more about luck than strategy). I continue to be a believer in this approach as a little bit can go a long way to reduce the extent to which the portfolio trades in line with the broad market.