What can we do to limit the potential losses or even profit from a decline?

The next stock market crash will inevitably come…

The ideal portfolio would be so well diversified amongst non-correlated assets that it would be able to maintain its value or even increase in a stock market correction.

During the global financial crisis (2007 – 2009), as risky assets largely declined in lockstep, U.S. bonds as measured by the Barclays Capital U.S. aggregate bond index returned 7.0%

Similarly, in August 1988, a prior contagion event, U.S. Bonds returned 1.6% while other types of assets posted negative returns:

  • US Stocks     -15.6%
  • High Yield Bonds     -5.5%
  • REITs (Property)     -9.4%
  • International developed markets     -12.4%
  • International emerging markets     -28.9%
  • Commodities     -5.9%

So, although bonds may not provide the long term expected returns of other asset and sub asset classes, they have been one of the more reliable assets to mitigate losses in the worst of times.

Combining assets with low historical correlation does not eliminate risk because of the tendency of all risky assets to become highly correlated in times of crisis. However, all is not lost because while assets with low historical correlation can move in the same direction, they rarely, if ever, move in the same direction with the same magnitude.

If we look again at the period from October 2007 through December 2012, a period representing the entirety of the bear market as well as the subsequent rebound, and focus on those days when the U.S. stock market was down 4% or more we see that although most risky assets declined in value on these substantially negative days, no two risk assets moved with the same magnitude. For example, on December 1st, 2008, when U.S. stocks returned a negative -9.2% only REITs lost more (-18.6%). Commodities, developed markets, emerging markets, and high yield bonds each declined, but to a lesser degree. From this perspective, these asset and sub asset classes did in fact offer a form of diversification to reduce equity risk.

Gold is frequently cited as a safe haven asset and certainly has the potential to diversify a portfolio, although it broadly tracked sideways during the financial crisis. In times of geopolitical stress, it has historically performed well relative to equities.

There is a category of investment known as “trend following” which is algorithmically driven and attempts to follow trends in all markets, whether up or down. They did particularly well in 2008 when the equity market slid lower throughout the year and subsequently attracted a lot of additional investor interest. Their subsequent performance has been more mixed.

Despite Japan having the highest government debt to GDP ratio amongst developed countries it is also the world’s largest creditor nation with money invested around the world because interest rates are so low at home. At times of crisis, the Japanese repatriate their money. The US$ lost more than 47% against the yen from the summer of 2007, just before the crisis began, to early 2012.

The infrastructure sector, which includes airports, bridges, toll roads, ports, telecommunications, power grids, energy pipelines and water facilities, could provide investors with a source of diversification in turbulent times.

Of the stock market sectors, utilities, telecoms, healthcare and consumer staples have proved to be consistently the most defensive.

And then of course there is plain old cash, held with robust institutions (up to the limit of government guarantees, currently £75,000 in the UK) or money market funds, which invest typically in short term government debt.

Below are some ETFs from the ETF Select 100 to consider which have the potential to be defensive.

 

The iShares Global Infrastructure ETF (INFR), though not in the ETF Select 100 because of a relatively high on-going charge of 0.65%, tracks the FTSE Global Core Infrastructure Index. It is listed on the London Stock Exchange and is denominated in GBP.

The ETFS Long JPY Short GBP (GBJP) is offered by ETF Securities Ltd, listed on the London Stock Exchange, denominated in GBP with an ongoing charge of 0.39%.

Below is what might be considered a typical investor 60/40 portfolio, with significant exposure to broad market indices such as the FTSE 100 or S&P 500 and how that allocation might change to make the portfolio more defensive.

The significant adjustments include:

  • A reduction of overall equity exposure to 40% from 60%
  • Reduced exposure to broad market indices via the addition of increased allocations to defensive sectors
  • An increased exposure to bonds, particularly longer dated bonds
  • The inclusion of exposure to a long Japanese Yen position in the alternative sector

defensive and normal portfolios

Definitions

  • crash – when the major stock indices fall 10% or more within a day or two
  • correction – when the major stock indices decline 10% over a week or more
  • bear market:     When the major stock indices fall 20% over two months or more

More on stock market crashes

This is part 3 of a 4 part series on stock market crashes.