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Posted by on Aug 29, 2014 in ETF Strategist

The Hard Work Of Portfolio Protection

The Hard Work Of Portfolio Protection

By Roger Nusbaum, AdvisorShares ETF Strategist

We spend a lot of time on this blog talking about portfolio protection in the face of large declines. There are several reasons for this including that actions taken as a result of emotion are what tends to get people in trouble and so protecting a portfolio from the full brunt of a large decline, if done successfully, goes a long way to reducing the likelihood of having an emotional reaction.

Additionally there is one school of thought related to portfolio management that long term results will beat the market by reducing the drawdown even if the upside lags the market (this is something I believe in).

One way to achieve this effect is owning investment products that track some sort of alternative strategy. An investor could maintain a static allocation to alternatives (it should be a small allocation) or tactically increase and decrease exposure to alternatives. There are pros and cons to both but either way can work.

In the last few years the number of choices in this space multiplied and whenever the next decline comes along many of these funds will do what they are supposed to but the reality is that some will not which makes the argument for small allocations to several different strategies for people who believe in these exposures in the first place. These strategies can include things like long/short, hedge fund replication, merger arbitrage, inverse funds, certain currency or commodity exposures and so on.

None of the above is new for the blog but it occurred to me that in navigating through choices and strategies that are designed to not correlate with the stock market there will be a lot of funds that will show less than inspiring results.

Source: Google Finance

The chart tracks an unnamed alternative-strategy mutual fund in blue and the S&P 500 Index in red. One of the intended attributes of this fund is that it should not look like the stock market. Based on the chart I would say mission accomplished; it does not look like the stock market but the result in nominal terms has not been good for the last few years. The market is up a ton and the fund down kind of a lot.

The point here is that investors who generally believe in this sort of exposure and who will start the process sifting through available choices will probably be looking at things that have not done well when compared to equities. It would be reasonably difficult to look at something that is down for the last four or five years and feel comfortable buying in.

At that point it becomes about what expectations the fund manager (or fund company) set. A fund that says it is going to have a negative correlation no matter what and then delivers that result is reasonably a successful product.

Something that bills itself as delivering an absolute return of some sort will either meet the expectation they set or not. If they come close, it will either be close enough or not (obviously a qualitative assessment).

For someone wanting this exposure broadly speaking, they will need to separate the emotion of seeing something that perhaps has not done with the reasoned thought of judging funds against their expectations.