It’s been a while since we’ve been in a bear market. Or has it? U.S. equities have zoomed since the market lows of March 2009, and investors since then have cashed in on one of the greatest bull markets in modern times. But some people believe the current run is just a cyclical bull market within an ongoing secular bear market that began in 2000 and which could, based on historical trends, last another several years.
Fears that the current rally lacks teeth due to weak economic growth and/or because of the perception it has mainly been fueled by central bank stimulus has some investors bracing for a pullback—or maybe worse.
But even if you aren’t a doom-n-gloom bear or believe we’re still in a secular bear market, it pays to be cautious and to think about adopting bear market strategies to some extent given the recent run-up in equities that has pushed some of the major indexes to new records this autumn. And on the fixed-income side, perhaps few bear market events have ever had as long a lead time as the expected rise in interest rates from historically low levels that will usher in the end of the bull market in U.S. bonds that began in 1981.
“Bear market strategies” is a broad concept entailing various means ranging from dedicated bear market funds to portfolio diversification to holding lots of cash.
“To me, bear market strategies are a hedge or a short-term fix,” says Christopher Zelesnick, senior managing director at Chicago’s Ziegler Wealth Management, which has 19 offices in nine states. “The hard part of investing is knowing when to get out. If you got out of the market six months ago, you would’ve missed a lot of gains because you would be sitting on cash. Instead of getting out, you can add a hedge to your portfolio.”
Regarding fixed income, he says advisors are preparing for the anticipated rise in interest rates by creating laddered bond portfolios that mature at different times, a technique that mitigates interest-rate risk. They’re also going into shorter-term bonds that are less sensitive to rising interest rates. He adds that Ziegler advisors are seeking alternative sources of income, such as dividend yield from preferred stocks.
On the equity side, Zelesnick says some of Ziegler’s advisors have diversified into global equities to protect against a potential pullback in U.S. stocks. And for clients who are approved for options strategies, he believes long put options can help protect equity holdings.
“It’s almost like buying insurance,” Zelesnick says, adding that you can’t lose more than the premiums paid for the options and that any gains from put options (which are short positions) would offset a market pullback.
Bear market mutual funds seem like a straightforward way to protect against a market downturn, but the group’s performance in recent years has been el stinko. Through November 8, the mutual funds in Morningstar’s bear market category collectively had lost 35%, 23% and 30% in the one-, three- and five-year time periods, respectively.
Morningstar’s bear-market mutual fund category comprises mainly inverse or leveraged-inverse passive index trackers. “It [bear market strategy] is the most difficult strategy to follow because the markets generally go up over time,” says Nadia Papagiannis, Morningstar’s director of alternative funds research.
Indeed, it’s hard to make money with a short bias in a market where U.S. equities, as measured by the S&P 500 index, have soared roughly 160% since the March 2009 lows. Bear market funds have done well in the past during market downturns, but Papagiannis doesn’t believe those fleeting moments of success make bear market funds a good deal for most investors after factoring in their high fees and their tendency to be on the wrong side of the market the majority of time. “It’s an expensive way to get tail risk insurance,” she says.
Regarding exchange-traded funds, most bear-market strategy products similarly are inverse or leveraged-inverse passive index trackers that target equities, debt or commodities. Not surprisingly, many of these funds have done poorly during the past several years.
But in fairness, you can’t judge bear market funds or inverse funds solely on total returns because they’re best used as tactical vehicles rather than as buy-and-hold investments. (Whether most investors have the market timing chops to be successful at tactical investing is another matter.)
The only two ETFs in Morningstar’s dedicated bear market category are both sponsored by AdvisorShares––the Ranger Bear Equity ETF (HDGE) and the Athena International Bear ETF (HDGI). Both funds are actively managed, equity-only strategies that eschew the use of derivatives. And they employ distinctive strategies that their respective fund managers believe can help them perform better than the average bear.
HDGE holds short positions in domestically traded equities based on the forensic accounting strategy from Ranger Alternative Management LP that seeks to identify securities with low earnings quality or aggressive accounting that might be intended to boost short-term results while covering up a longer-term deterioration of a company’s fundamentals. The fund’s portfolio managers also look for events such as lowered earnings revisions or reduced forward guidance that might cause a stock to tumble.
The fund debuted in January 2011 and generated sizable returns when equities sank that autumn, but it has trended downward––notwithstanding another rally during the mid-2012 downturn––since then. “We haven’t been in an atmosphere conducive to falling stocks,” says fund co-manager John Del Vecchio. “But the longer this goes on [the bull run in equities], the bigger the downside will be and nobody knows when that will occur.”
Del Vecchio says the best way to use HDGE is to pair it with a long-only index ETF as part of a long/short strategy to guard against a market downturn. “We’re designed to be a piece of a portfolio to provide some protection,” he says, adding that the fund can be included in the alternative assets sleeve of an investment portfolio, and in most cases shouldn’t comprise more than 5% of a total portfolio.
As of early November, HDGE’s top five holdings were Caterpillar, Diebold, Consolidated Communications, CenturyLink and Tempur Sealy. The fund’s net expense ratio is a hefty 3.29%, including a management fee of 1.50% and a short interest expense of 1.51%. The fund’s recent asset base was $157 million.
AdvisorShares’ other bear strategy fund, HDGI, holds short positions in international equities. The fund is managed by AthenaInvest Advisors LLC, which employs its patented behavioral finance approach to identify which securities to short.
As described in the fund literature, Athena measures manager behavior and strategy consistency and conviction, and it identifies which stocks are held in top and bottom relative weight positions. Short positions are selected from the lowest-conviction holdings in the international equity universe and are allocated based on market capitalization.
HDGI debuted this past July, sports an expense ratio of 2.00% (including a management fee of 1.35% and a short interest expense of 0.50%), and was down 6.67% as of November 8. The U.K. is the top country weighting within the fund’s portfolio, and recent top holdings included SAP, Toronto-Dominion Bank, Lloyds Banking Group, UBS and Telefonica.
“As a strategy, shorting is a very important part of the markets and the pricing of the markets,” says fund manager C. Thomas Howard, founder of AthenaInvest. “Shorts are simply another way to express your opinion because you can short stocks you don’t think are very good.”
Howard says the fund is intended to be used by investors to hedge their international positions in a long/short pairing with an international long-only index fund, and for tactical investing if you think international stocks are heading south.
Adam Levy, a registered rep at JHS Capital Advisors in Bellevue, Wash., says he doesn’t use bear market funds and instead prefers other strategies to deal with the market’s ups and downs. “If you look at where a client is in his or her investing life, there are products designed to mitigate bear market downturns and protect income,” he says.
For some clients, he notes, that could mean annuities. Or perhaps income-producing alternative investments that theoretically have a lower correlation to stocks and bonds, such as real estate investment trusts and master limited partnerships.
In cases where he believes it’s suitable, Levy will use an inverse Treasury ETF to protect against rising interest rates. “When you construct a client’s portfolio, you have to consider how an investment would do in a bear market,” Levy says.
A bear market––or at least a painful market correction––is coming. They always do. And as 2013 draws to a close with the well-choreographed end of the long fixed-income bull market looming on the horizon, and with reports that retail investors are feeling bullish about stocks and jumping into the market after the long bull rally (an often-reliable sign of a market top), advisors who haven’t done so already should be looking at strategies that could help protect client portfolios against an inevitable downturn.