For years, many financial advisors gave clients standard advice: Buy a diversified portfolio of stocks and bonds and hold it through up and down markets. Portfolios should include foreign and domestic stocks as well as corporate and government bonds, advisors said.
If one investment sank, others were bound to stay afloat and enable investors to avoid big losses. But when markets crashed in 2008, the old advice about diversification failed to provide much protection. The problem was that most kinds of investments fell at once. In the depths of the financial crisis, only Treasury bonds and cash held their values.
Where to place your assets
Faced with a shifting environment, financial advisors have been rethinking their strategies. A growing minority is urging clients to take new defensive measures. Some advisors are telling clients to hold big stakes in Treasury bonds. Another defensive approach is to use stock mutual funds that shift to cash when markets look expensive. “People thought that corporate bonds or foreign stocks would protect them, but that kind of diversification didn’t help,” says David Darst, chief investment strategist of Morgan Stanley Smith Barney.
In the past, Darst urged some clients to keep most of their assets in stocks. But these days he is recommending bigger doses of government bonds. For moderate-risk clients, he suggests keeping only 33% of assets in stocks. He puts 10% in government bonds and 7% in cash. Darst is keen on Treasury Inflation-Protected Securities (TIPS). Like other bonds, TIPS pay a fixed yield.
In addition, the principal value of the inflation securities rises along with the consumer price index. Say you invest $1,000 into TIPS, and inflation rises 3%. By the end of the first year, your principal value will have climbed to $1,030. Because they provide inflation protection, TIPS tend to be resilient, sometimes rising when stocks are declining.
Shifting between bonds and stocks
Some financial advisors recommend funds that have the ability to shift between bonds and stocks. When markets look risky, the funds sell their stocks and invest in fixed income. Managers of the funds concede that they sometimes make mistakes, selling stocks when markets are still rising. But by holding cash and bonds in downturns, the funds often limit losses.
Among the most notable performers in recent downturns has been Columbia Thermostat, which returned 3.8% annually during the past five years and outdid the S&P 500 by 5 percentage points, according to Morningstar. The fund follows a mechanical formula that aims to buy stocks when they are cheap and sell when they become dear.
When the S&P 500 is under 1000, Thermostat keeps 90% of assets in stocks and 10% in cash and bonds. As the market rises, the fund sells stocks and shifts to fixed income. When the index tops 1750, the fund will only hold 10% in equities. With the S&P recently at 1315, the fund had 60% in equities and 40% in fixed income. Portfolio manager Charles McQuaid says that the fund doesn’t always get it right. “We make a judgment call about when stocks look cheap, and the best we can do is predict in a rough range,” he says.
The Columbia managers designed the fund after studying market history and noticing that stocks often move in patterns. For periods of about two decades, markets tend to rise. Then there are long periods when stocks go nowhere. One of the greatest rallies of all time occurred from 1982 to 2000. The rally ended when the Internet bubble burst. Studying the losses, the Columbia managers figured that markets were due for a long period of churning up and down. The Thermostat fund aimed to produce profits in the frustrating times.
Funds that are succeeding
Since it was started in 2002, the fund has mostly succeeded, outdoing both stocks and bonds. But Thermostat does not excel every year. The fund trailed the S&P 500 from 2003 through 2006. During that time, stocks mostly rose. As the S&P 500 climbed, Thermostat gradually sold shares. The low stock allocation hurt the fund in the boom times. But when the financial crisis unfolded, Thermostat had big fixed-income holdings that provided protection.
Another fund that protected shareholders during the downturn is Stadion Managed Portfolio. In 2008, the fund lost 5.8%. The result may look uninspiring, but Stadion outpaced the S&P 500, which lost 37%. The fund follows trends, loading up on stocks when they are rising and selling when markets hit the skids. Stadion began shedding stocks in October 2007 when prices starting turning down. By late 2008, the portfolio was 100% in fixed income.
Because Stadion waits to buy stocks until a rally has started, the fund often misses part of the gains that occur in bull markets. That does not trouble portfolio manager Brad Thompson. “If we can limit losses in downturns, then we will do quite well over the long term,” says Thompson.
Stadion began 2012 with big stock holdings. Then in April the market began weakening, and Stadion shifted to all cash. At first the move seemed premature. Then investors began worrying that trouble in Spain and Greece could spread to global markets. That pushed down stocks. During the May downturn, Stadion outdid 99% of its peers. Financial advisors who recommended the fund could feel satisfied that they protected clients from a period of rough markets.