COLUMN-How to catch the market's upside with a downside cushion

Reuters

By John Wasik

CHICAGO, Nov. 25 (Reuters) - Sometimes the very name of afund sounds like a security blanket if you're a risk-averseinvestor. Case in point: "Managed volatility funds" promise someof the stock market's upside with a cushion on the downside.

This burgeoning class of more than 400 funds is gaining agaggle of devotees. There is more than $200 billion invested inthem, according to Strategic Insight, up from $31 billion in2006. While "managed volatility" isn't well defined, these fundsprovide a strategy that dampens volatility over time.

So why worry about market volatility when the marketcontinues to head higher and both the Dow Jones IndustrialAverage and S&P 500 Index keep hitting new highs? Because marketdownturns are often unpredictable and the overall risk of lossnever goes away. Yet while volatility funds provide some cushionfrom frenetic markets, you pay a price for modest protection.

Take the BlackRock Managed Volatility Investors A fund, which is one of the largest funds in the categorywith more than $600 billion in assets. The fund has gained about14 percent for the year through Nov. 22. While that's less thanhalf the return of the S&P 500 during the same period, keep inmind that the fund is taking long and short positions in thestock market to hedge risk.

Like most of the managed volatility funds, the BlackRock fund is an expensive holding. The "A" share class leviesa 5.25-percent front-end sales charge and charges 1.27-percentannually in additional expenses.

It also costs a lot to execute an active managed volatilitystrategy. Unlike a static, umanaged index fund, the BlackRockfund has a whopping turnover of 324-percent annually, which addseven more to the heavy expense burden (expenses related to thosetransactions don't show up in the expense ratio). That's thepercentage of the portfolio that's bought and sold in a year.

A similar fund - the AllianzGI US Managed Volatility A - tells much the same story with a 5.5-percent salescharge and 0.96 percent in annual expenses. The fund's return,though, is much better than BlackRock's; it's up 23 percent forthe year through Nov. 22.

Since you're paying a steep price for downside protection,the real test is how well these funds did in 2008, a wretchedyear for volatility in which the S&P 500 index lost 37 percent.The Allianz fund lost 41.5-percent that year while the BlackRockfund dropped only 27 percent.

BETTER ALTERNATIVES

One of the flaws in the managed volatility approach is thepromise that you can head off and manage future volatility. Thenthere's the conceit of active management that implies that youcan trade your way out of a market decline - or at least bracethe portfolio from larger losses you can't predict.

Don't even pretend that active management will anticipatefuture market meltdowns. It's best to keep it simple whenlooking at a hedge against stock-market risk. Just reduce yourstock holdings to a comfortable level - say under 60 percent -and replace them with bonds.

Since bonds pose their own kinds of problems and can losemoney when interest rates or inflation rise, fill your bondbucket with a bond index fund like the Vanguard Total BondMarket ETF and the iShares TIPS Bond ETF, whichholds inflation-protected securities that gain when thecost-of-living index rises.

Why do these funds work as better hedges than managedvolatility funds? The Vanguard fund gained nearly 8 percent in2008 when just about everything else was tanking. The iSharesfund was down only one-half a percentage point.

And for those frugal investors who don't want to pay toomuch for a reliable hedge strategy, there's another advantage:The bond ETFs are bargains. Vanguard charges 0.10 percentannually to hold virtually the entire U.S. bond market; iShareslevies 0.20-percent in expenses.

Of course, most investors are probably thinking why evenworry about hedging when the S&P 500 is up 32 percent over thepast year and the U.S. economic outlook continues to improve.

A correction will come, possibly when the Federal Reservedecides to phase down its bond-buying program. "We are lookingfor a near-term decline in the S&P 500 back down toward the1,770 to 1,780 area before the next major wave to the upsidebegins," according to S&P Capital IQ's Alec Young, aglobal equity strategist.

Don't wait for the next downturn. Now is the ideal time tobuild a hedging combination; not when investors are bolting fromthe market during the next correction.

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