Sometimes the best offense is a good defense. Keeping what you have can be as important as growing what you have. Assuming your investment portfolio is already well diversified and positioned not to take unnecessary risk, here are some portfolio strategies to consider.
Stock Side of Portfolio
Utilities Fund: These funds invest primarily in gas, water, and electric companies. Utilities have long been considered a good defensive sector. Even in a poor economy, these are some of the last services people default on. While it is not wise to load up on sector bets, a utilities fund can be worked into the portfolio. Usually classified as a Large Value fund, they could replace a portion of your traditional Large Value funds. Besides providing defense, they can also increase the yield of the portfolio as they tend to have higher payouts. However, be aware that a utilities fund will usually under-perform in a growing market.
Funds to consider: IDU, XLU, VPU, FSUTX
Preferred Stock Fund: Owners of preferred stock have payment priority over common stock (dividends, liquidation). As a hybrid between stocks and bonds, preferred stock funds are usually less volatile than broad market indices like the S&P 500. With higher payouts, they can also increase the yield of the portfolio. Preferred stock funds tend to classify as a Large Value fund because they mainly hold bank and other financial company stock. Like utilities funds, their performance will usually lag in a bull market.
Funds to consider: PFF, PSK, DFP
Covered Call Fund: These funds sell call options, which give the buyer the right to purchase a stock at a set (strike) price within a certain time period. When the fund owns the stock it’s selling options on, it’s called a “covered” call option. If it doesn’t, it’s referred to as a “naked” call option and that is riskier. The funds collect premiums on the calls they sell and that income is distributed to shareholders. The income from a covered call fund can turn a flat market into a profitable one and help offset losses in a down market. However, your upside is also limited as the fund won’t participate in the gain above the strike price. It is important to research any investment before purchasing, but especially covered call funds, as many have higher expense ratios and some even use leverage.
Funds to consider: ETV, ETB, EOS, BDJ
Use Stop-Loss Orders: A stop-loss order is designed to limit an investor’s loss on an investment by selling it when a certain price is reached. Stop-loss orders cannot be used with traditional mutual funds. They can only be used for Exchange Traded Funds (ETFs) and individual stocks. If you bought an ETF that tracks the S&P 500 index at $50/share, you could enter a stop-loss order at $44/share knowing you are limiting your downside, but yet keeping your upside intact. If the ETF increases to $60/share, you could put in a new stop-loss order at $55/share to lock in a profit should the market head south.
While stop-loss orders can protect against large losses, they can also work against you. Most people envision a worst-case scenario when thinking about stop-loss orders (If I buy a fund at $50 it could drop to $25, I better do a stop-loss). In reality, stock funds slowly move up and down, and often reverse course. In the two scenarios above, consider what you would do if your investment dropped to the stop-loss order price, it executed, and then the investment started to climb again? A buy-and-hold investor would still receive those gains, but you’d be sitting in cash. It is paramount to have a game plan in place for getting back into the position/market when using stop-loss orders. Search for “flash crash” for a great example of how stop-loss orders could work against you.
Market Hedging Funds: Not to be confused with “hedge funds”, market hedging funds are basically funds that perform inversely to a segment of the market like the S&P 500. If the S&P 500 is down 10%, you can expect a market hedging fund to be up about 10%. In a down market, a stop-loss order can limit your losses, but you could actually make money with a market hedging fund. These funds are typically more expensive and, of course, perform terribly in a bull market. However, a small dose in your portfolio may help ease your mind. Again, do your research.
Funds to consider: SH, PSSDX
Less Stocks / More Bonds: One of the easiest ways to play defense with your portfolio is to simply reduce your stock percentage and increase your bonds. A lower stock percentage should lessen the volatility of your portfolio. Keep in mind though, that your portfolio allocation is meant to help you reach your short-term and long-term goals. A portfolio that is too conservative may leave you short of those goals. Market timing and over-active trading are never recommended. However, if you’re nervous about the market, a reduction of stocks could allow you to sleep easier. It could also have less of an impact than if one day you decided to sell everything and go to cash.
Bond Side of Portfolio
Increase Credit Quality: The two biggest risks to bonds are credit risk (default) and interest rate risk (rate fluctuations). By selecting bond funds holding higher rated bonds, you can decrease your credit risk. This might mean decreasing or even eliminating exposure to high yield (lower quality) bonds. The more you increase the creditworthiness of your bond portfolio though, the lower the expected yield will be.
Lower Duration: Duration, expressed in years, is a measure of a bond investment’s sensitivity to a 1% change in interest rates. If a bond fund has a duration of 5 years and interest rates go up 1%, you can expect the bond fund to lose about 5% in value. By lowering the duration of the bond funds you have in your portfolio, you can lower your interest rate risk.
Bond Ladder: A bond ladder is simply a collection of individual bonds with varying maturity dates (ex. bonds with maturities every 6 months for the next 5 years). Bonds held until maturity have very little interest rate risk. Barring an emergency sale by you or default on the issuer’s part, you would pretty much lock in your interest and principal over the term of the ladder. A bond ladder could be used in place of traditional bond funds if interest rate risk is a concern. Just keep in mind that with individual bonds, there’s more concentration risk and pricing risk (bigger spreads and lack of transparency).
Target Maturity Bond Funds: These are bond funds that hold their bonds until maturity. They are available in various maturities for investment grade, high yield, and inflation-protected bonds. You could buy certain ones to mix in with your regular bond funds, or you could build a “bond ladder” with them. You won’t get the customization of a true bond ladder, but you do get simplicity (less hassle building a ladder) and more diversification (many funds hold hundreds of bonds).
Funds to consider: IBDK, IBMI, FOCFX, BSJJ
Floating Rate Bond Fund: Floating rate bonds have variable rates, meaning their rates often move with the market. They are usually short-term in nature, but may have lower yields vs. comparable fixed rate bonds. It’s important to know the make-up of a floating rate bond fund as many hold lower credit quality bonds.
Funds to consider: FLOT, FLRN
Terry Green, CFP® is the owner of Blue Water Capital Management, LLC, a fee-only financial advisory firm in Apex, NC.
