COLUMN-How to catch the market's upside with a downside cushion

Mon Nov 25, 2013 12:31pm EST

By John Wasik

CHICAGO, Nov. 25 (Reuters) - Sometimes the very name of a fund sounds like a security blanket if you're a risk-averse investor. Case in point: "Managed volatility funds" promise some of the stock market's upside with a cushion on the downside.

This burgeoning class of more than 400 funds is gaining a gaggle of devotees. There is more than $200 billion invested in them, according to Strategic Insight, up from $31 billion in 2006. While "managed volatility" isn't well defined, these funds provide a strategy that dampens volatility over time.

So why worry about market volatility when the market continues to head higher and both the Dow Jones Industrial Average and S&P 500 Index keep hitting new highs? Because market downturns are often unpredictable and the overall risk of loss never goes away. Yet while volatility funds provide some cushion from frenetic markets, you pay a price for modest protection.

Take the BlackRock Managed Volatility Investors A fund , which is one of the largest funds in the category with more than $600 billion in assets. The fund has gained about 14 percent for the year through Nov. 22. While that's less than half the return of the S&P 500 during the same period, keep in mind that the fund is taking long and short positions in the stock market to hedge risk.

Like most of the managed volatility funds, the BlackRock fund is an expensive holding. The "A" share class levies a 5.25-percent front-end sales charge and charges 1.27-percent annually in additional expenses.

It also costs a lot to execute an active managed volatility strategy. Unlike a static, umanaged index fund, the BlackRock fund has a whopping turnover of 324-percent annually, which adds even more to the heavy expense burden (expenses related to those transactions don't show up in the expense ratio). That's the percentage of the portfolio that's bought and sold in a year.

A similar fund - the AllianzGI US Managed Volatility A - tells much the same story with a 5.5-percent sales charge and 0.96 percent in annual expenses. The fund's return, though, is much better than BlackRock's; it's up 23 percent for the year through Nov. 22.

Since you're paying a steep price for downside protection, the real test is how well these funds did in 2008, a wretched year for volatility in which the S&P 500 index lost 37 percent. The Allianz fund lost 41.5-percent that year while the BlackRock fund dropped only 27 percent.

BETTER ALTERNATIVES

One of the flaws in the managed volatility approach is the promise that you can head off and manage future volatility. Then there's the conceit of active management that implies that you can trade your way out of a market decline - or at least brace the portfolio from larger losses you can't predict.

Don't even pretend that active management will anticipate future market meltdowns. It's best to keep it simple when looking at a hedge against stock-market risk. Just reduce your stock holdings to a comfortable level - say under 60 percent - and replace them with bonds.

Since bonds pose their own kinds of problems and can lose money when interest rates or inflation rise, fill your bond bucket with a bond index fund like the Vanguard Total Bond Market ETF and the iShares TIPS Bond ETF, which holds inflation-protected securities that gain when the cost-of-living index rises.

Why do these funds work as better hedges than managed volatility funds? The Vanguard fund gained nearly 8 percent in 2008 when just about everything else was tanking. The iShares fund was down only one-half a percentage point.

And for those frugal investors who don't want to pay too much for a reliable hedge strategy, there's another advantage: The bond ETFs are bargains. Vanguard charges 0.10 percent annually to hold virtually the entire U.S. bond market; iShares levies 0.20-percent in expenses.

Of course, most investors are probably thinking why even worry about hedging when the S&P 500 is up 32 percent over the past year and the U.S. economic outlook continues to improve.

A correction will come, possibly when the Federal Reserve decides to phase down its bond-buying program. "We are looking for a near-term decline in the S&P 500 back down toward the 1,770 to 1,780 area before the next major wave to the upside begins," according to S&P Capital IQ's Alec Young, a global equity strategist.

Don't wait for the next downturn. Now is the ideal time to build a hedging combination; not when investors are bolting from the market during the next correction.

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