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What if 2008 happened again? New techniques offer promise to minimize downside

BY JERRY MICCOLIS

COMMENTARY

The holy grail of investing is a portfolio that doesn't go down when the stock market plummets, but goes fully along for the ride when the market soars.

There are still no magic bullets, but some new investing strategies are emerging that can help protect a portfolio from major losses and still offer plenty of upside.

Brinton Eaton research, based out of Madison, N.J., on market crises offers these lessons:

Use alternatives more. We now invest up to 35 percent of our clients' assets in "alternative" investments, which include managed futures, market neutral and absolute return strategies, in addition to real estate and commodities. Managed futures generally go up when commodities either have a strong bull market or a strong bear market. Market neutral strategies attempt to provide equity-like returns, but with low correlation to equity markets themselves, which make them great diversifiers. Absolute return strategies attempt to provide positive returns regardless of what the markets are doing.

Diversify your mainstream investments more than ever. Look to small-cap international and emerging market stocks. Also consider investments in timberland, agribusiness, and global infrastructure.

Use new kinds of investment to hedge against extreme drops. The ideal portfolio hedge is one that kicks in when you most need it, but doesn't represent a drain on your portfolio in normal times. Until recently, nothing did that at a reasonable cost — i.e., without requiring a sizeable capital outlay that would divert too much of your portfolio from productive purposes.

However, a new approach designed by Deutsche Bank, called EMERALD, works by exploiting a phenomenon about the equity market's behavior. The S&P 500 index moves quite a bit from day to day, but rarely goes in the same direction for very many days in a row. Its movement from week to week is typically less than daily movements would imply. There are usually intra-week reversions - even during market collapses. EMERALD exploits this behavior by betting on this phenomenon each day. In the long run, the strategy wins. But the principal reason Brinton Eaton has EMERALD in client portfolios is its expected behavior when markets go into a tailspin, as they did in the fourth quarter of 2008. In those situations, it is expected that EMERALD would dramatically appreciate, offering close-to-ideal portfolio protection.

The way Brinton Eaton invests in EMERALD is through a custom-designed investment product called a "structured note," a promissory note issued by Deutsche Bank. The note contains two index components. One is the S&P 500 Stock Index, and the other is EMERALD — you get exposure to the S&P 500, with EMERALD attached to it. The cost built into the note is less than the expected growth in the note beyond whatever the S&P 500 does.

The protection should pay for itself. It may not, but we believe that chance is small.

There are some risks associated with this structured note, but Brinton Eaton's analysis indicates that they are commensurate with the expected benefit.

The protection is not perfect, but it the best we have seen so far. And, we continue to research products and strategies that will protect our clients when the markets don't cooperate.

Brinton Eaton has produced a podcast on this topic. To listen to it, visit http://www.brintoneaton.com/resources.aspx.

Jerry Miccolis, Chief Investment Officer at Brinton Eaton, is a leading authority on asset allocation. He is also author of Asset Allocation For Dummies (Wiley 2009).