COLUMN-Nervous Nellies take safe road to capital preservation
By John Wasik
CHICAGO Nov 26 (Reuters) - Nervous Nellies can't stand losing money, so they typically hedge their portfolios with investments seeking to preserve capital. With the fiscal cliff looming, there are a lot more of these worriers out there who are (temporarily) looking to put together worst-case scenario portfolios.
Whether you think that the fiscal cliff crisis won't be resolved by the end of the year or fear inflation, a calamity-proof portfolio can hedge against any number of perils. This would be a prudent approach for anyone primarily focused on capital preservation or a subset -- possibly 40 percent -- of a larger portfolio in which you need to temper stock-market risk. You can create it yourself or buy it off the shelf in the form of a mutual fund.
When looking to safeguard your money, keep in mind that this is not an aggressive or moderate growth portfolio. If you're young, can afford to take some risk or have a solid guaranteed pension waiting for you, this is not an ideal strategy for you.
One way to go is the iShares Barclays 7-10 Year Treasury bond fund ETF, which has returned almost 8.5 percent during the last five tumultuous years through Oct. 30. It's up 3.6 percent year to date. While this fund has some interest rate risk -- its value will decline if rates climb -- there's negligible credit risk if the U.S. pays back its creditors.
Because they fear the worst in terms of the dollar's further decline and seek safe havens from global turmoil, conservative investors also favor gold, best purchased through the SPDR Gold Trust, which holds bullion in a vault in London. The fund's price is linked to the over-the-counter market for the pale metal. In the event of the U.S. government falling over the fiscal cliff -- triggering some $600 billion in taxes and possibly a recession -- gold would be somewhat of a refuge.
Another calamity hedge against U.S. stocks are inverse exchange-traded funds linked to U.S. stock indexes. When stocks fall, they rise in value. Say you wanted some protection against a decline in the largest U.S. stocks in the S&P 500 index. A fund like the ProShares Short S&P 500 ETF is a consideration. If you wanted twice the inverse movement of the index, then a leveraged ETF such as the ProShares Ultrashort S&P 500 would be a choice.
With inverse ETFs, though, you need to heed a whole set of risk factors. They will lose money if the market rises and they don't always track market indexes precisely. It's unwise to make an "all-in" bet on these risky ETFs.
What if you wanted to hold a small position in stocks that you will keep long after the fiscal storm blows over? Consider the Vanguard Health Care Index fund, which has relatively low volatility and holds durable, mature companies like Johnson & Johnson and Merck. S&P Capital IQ, a financial services data provider, is currently recommending an "overweight" position for the fund. Healthcare stocks offer a modest defensive position for investors who are concerned about short-term volatility.
If you wanted to create a weather-the-storm kind of portfolio with the above funds, I would suggest 60 percent in the bond fund, 20 percent in gold, 10 percent in the inverse stock fund and 10 percent in the healthcare ETF.
One of the best ways to find most of what I've recommended above in one package -- and then some -- is through the Permanent Portfolio. This low-risk portfolio has long been a favorite of nervous nellies.
Designed for inflation-obsessed investors, it features a 35 percent stake in U.S. Treasury bonds, 25 percent in gold and silver; 10 percent in Swiss Franc assets; 15 percent in U.S., foreign real estate and natural resources and 15 percent in aggressive growth stocks.
More than half of the portfolio is geared to protect you against dollar devaluation and stock declines and a commodity inflation hedge through real estate and natural resources stocks. It's largely constructed to "preserve and increase the purchasing power of each shareholder's account over the long term."
While the Permanent Portfolio has proven it can hold up well in the worst markets -- it only lost 8.4 percent in 2008 -- it will underperform a growth-oriented approach that will benefit from broad-based economic prosperity. It simply won't capture the gains of a diversified stock fund such as the Schwab S&P 500 Index fund. Over the past year, the Schwab fund is up 15 percent through Oct. 31 versus 6.4 percent for the Permanent fund.
The biggest downside with a conservative strategy is opportunity risk. If the fiscal cliff comes and goes without a huge sell-off or if inflation remains tame, you will be missing out on a stock rebound that's been in progress with fits and starts for more than three years. That's why it makes sense to pick and choose among the portfolio risks you most need to hedge against. Preserving capital and keeping inflation at bay always seem to be perennial concerns.
Yet if you're looking for capital preservation with volatility that's often half that of the S&P 500, the Permanent Portfolio or my suggestions above can get you through major crises with minimal bruising.