Whenever the stock market shows a bad hand, as it did in the third quarter, nearly all stock investors hope they have something akin to an ace in the hole.
Investing professionals call this favored-card strategy “portfolio insurance,” a way of hedging against the brutal loss of a broad-based market decline. In recent years, more specialized investments to stem market downturns have become available to individual investors.
Although portfolio-protection strategies are complicated and none work perfectly, they can be widely employed to protect wealth over time. But shielding against future loss in retirement income and addressing short-term volatility are often two different missions that have varying costs and results.
What most unnerves many investors is volatility, the day-to-day sell-offs that can shave up to 3 percent off stock prices; this happened more than once in August. To safeguard against those Tilt-A-Whirl rides, people can turn to investments that actually reward them in the most skittish periods. That approach would have paid off in August, when the Standard & Poor’s 500-stock index lost 6 percent, and in September, when it lost nearly 3 percent.
Nine exchange-traded funds, known as E.T.F.s, are linked to indexes that track stock volatility. The idea behind these funds is that when short-term fears derail stock returns, investors can make still money. The funds follow a “fear” index listed by the Chicago Board Options Exchange that gains when stocks head south.
The largest fear E.T.F. by assets is the VIX Short-Term Futures E.T.F. (VIXY). The fund was up 27 percent for the third quarter, a handsome return considering the S.&P. 500 was down 6 percent during that period.
As investors have become more skittish during market dips, trading in the volatility products has soared. In August, the C.B.O.E. reported that trading in such funds was the “second-busiest of all time,” eclipsed only by the 2008 collapse.
But when the market flattens out or posts gains, the returns on fear-index funds are abysmal. The ProShares fund is down 49 percent over the last three years as of Oct. 19. As with all short-term trading funds, investors have to be fairly precise about when they enter and exit this E.T.F., which is not something most individuals can do with consistent success.
Another strategy that has grown in popularity among individual investors in recent years is the low-volatility or smart beta stock approach. These funds select stocks that don’t have as much downside movement as the rest of the market, may offer growth and are often less prone to huge declines because they pay consistent dividends.
“I love the idea of stock growth and lower portfolio risk,” said Howard Erman, a certified financial planner in Seal Beach, Calif. “The idea is to manage volatility and not avoid it. That means investing in stocks and having confidence in the growth of the global economy. Every bear market ends. When it does, you need to be invested in stocks.”
While low-volatility funds can and do lose money in a downturn, their losses are not as great as that of the S.&P. 500. Steve Stanganelli, a certified financial planner with Clear View Wealth Advisors in Amesbury, Mass., recommended the iShares MSCI USA Minimum Volatility E.T.F. (USMV), which owns durable dividend payers such as AT&T Inc. (T) and Procter & Gamble (PG). The fund was down slightly more than 1 percent in the third quarter, compared with more than 6 percent for the S.&P. 500.
A more active approach to portfolio protection can be found through hedgelike or alternative mutual funds, which can skew a portfolio toward making money on the downside if market conditions warrant. You can also invest in commodity and real estate funds that tend not to move in lockstep with stocks of American companies most of the time (except for 2008).
The managers in these funds are free to home in on securities that could do well during a downturn, or to “short” companies — that is, to make money when the companies decline in value.
Returns for the more than 100 long-short funds on the market, however, vary widely and are expensive to own. The Turner Medical Sciences Long/Short Fund (TMSFX), for example, is up 20 percent for this year, through Oct. 19. It holds mostly small health care growth stocks.
Be careful with any active strategy, because managers can still guess poorly or whole industries can fall out of favor. Then you will pay dearly for their mistakes and will not have the downside protection you seek.
For even more sophisticated investors, options — bets that a security or index will rise or fall over a given period — can provide some downside protection.
You can, for example, buy “put” options on a single stock or an entire index, which pay off if a security declines over a specific time. For this strategy to make sense, you need to have some understanding of how options work; commissions and taxes are involved. It may be helpful to work with an adviser who specializes in options.
For most investors, though, a comprehensive portfolio review that involves a combination of strategies can smooth out some of the bumps. Most, if not all, certified financial planners, chartered financial analysts and registered investment advisers can model the portfolio that will allow you to sleep at night.
You can, of course, set up your own portfolios or go online to create one through a robo-adviser such as Betterment, Wealthfront or Personal Capital. But if you have some specific needs such as saving for college, a late retirement or tax reduction, a personal adviser can do some hand-holding and perhaps better tailor an investment plan to your risk and return goals.
Mr. Stanganelli, for example, uses a broad array of low-volatility, option-based and dividend-focused funds in his client portfolios, which are customized according to goals and risk tolerance.
“The market’s going to be volatile and things change,” he said. “But as long as you have a plan, there’s no need to panic as long as you’re meeting your goals.”
If you choose to work with an adviser, ask that any suggested portfolios be “stress tested” so you can see how much money you would lose under a 10 percent, 20 percent or 2008-scale sell-off. Then you can determine which hedging strategy feels right to you.