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Posted by on Jan 29, 2014 in ETF Strategist, Investment Perspective

Do Portfolio Diversifiers Belong in Client Portfolios?

By Roger Nusbaum, AdvisorShares ETF Strategist

The other day in reaction to our post on gold’s role in a diversified portfolio well known blogger and CNBC contributor, Josh Brown, engaged us in a discussion via Twitter when he asked;

If the world goes to hell, and I have 5% of my portfolio in $GLD, how exactly has that helped me?

Our reply over two tweets;

My answer is gold as one of several holdings that tend to not look like equities, reducing extent to which the overall portfolio gets hit may not work the next time but did work before, been saying this many years.

Where the context is whether or not to use portfolio diversifiers like gold, of course gold is not the only choice available, the issue becomes how advisors can effectively use portfolio diversifiers for their clients.

The big idea is that the stock market goes up more often than not but when it does go down it scares the hell out of clients. During these large declines some advisors will use tools like gold, hedge fund replicators, absolute return, market neutral, funds that sell short or any other products that tend to not look like the stock market to try to spare clients from the full effect of the decline.

The use of portfolio diversifiers is not a static allocation. If stocks go up most of the time then the need for diversifiers lessens during the bull phase of the cycle. During bear phases of the cycle the potential utility of more diversifiers in the portfolio increases. Used effectively, these types of diversifiers can serve to improve risk adjusted returns.

The use of portfolio diversifiers was written about often during the last bear market and now after a five year rally for stocks the discussion is ramping up again. This past weekend Barron’s Fund of Information column explored the use of hedge funds by members of congress as portfolio diversifiers, joking that this might be the only thing that democrats and republicans can agree on.

While no one can know with any certainty when the next large decline is coming we do know that at some point as a function of normal market behavior there will be another very large decline and it will again scare the hell out of clients. And when that occurs, clients will be looking to their advisors to try to protect their portfolios from the full brunt of that large decline.

In general terms, a time to consider increasing exposure to portfolio diversifiers would be after a huge rally in the market. More specifically, a time to consider adding or increasing exposure to portfolio diversifiers would be when the equity market shows signs of price deterioration or a slow rolling over of prices.

Bear markets historically have started slowly over a period of several months not with crashes. Take a look at where the S&P 500 was six months after their respective 2000 and 2007 peaks. According to Yahoo Finance, the S&P 500 was only down 5% six months after its peak in 2000 and six months after the 2007 peak it was only down 7.7%.

After almost five years of market gains it makes sense to start thinking about slowly adding in portfolio diversifiers. Things like gold and hedge fund replicators have helped in the past but of course that is no guarantee they will work in the future but whenever the market does roll over again advisors will want their clients’ portfolios to look less like the stock market than it should have in the last few years.