In Defense of Defense

It’s football season—and we’re excited to cheer on our hometown Denver Broncos. As we’ve all observed in the August preseason games, NFL coaches have been testing their teams and making roster changes to ensure that they have the best offense and strongest defense on the field when the regular season begins.

Investors should be doing the same and evaluating their portfolios so they’re ready for whatever conditions lie ahead. But, it’s easy to get carried away by the headline numbers indicating just how good things are at present. It’s just as easy to forget that all that good news is already priced into the market.

Investing is always a forward-looking endeavor, and therefore, the only question that really matters is, what’s the market missing?

According to Morningstar, as of July 31, investors added $159B to stock funds and ETFs over the past year, which when combined with market performance, put overall stock allocations in the aforementioned spitting distance of their all-time highs. Now in fairness, investors do appear to have been thinking about diversification, as they’ve also added $272B to bond funds and ETFs. Investment grade debt, which accounts for most of those inflows, has traditionally played a crucial role in diversifying equity risk. But that was when investment grade debt offered a meaningful real return on an ex-ante basis; we can’t say that today.

While the alternative mutual fund categories haven’t exactly lit it up over the past year, the Managed Futures (+0.7%), Long/Short Credit (+1.2%), Market Neutral (+1.2%), Options Based (+5.1%), Long/Short Equity (+6.0%), and Multialternative (+2.0%) categories have all outperformed Intermediate-Term Bond (-0.7%)—the single largest fixed income category.

We’re not saying that any of these strategies have comparable risk profiles to investment grade debt and are therefore appropriate one-for-one replacements. Rather, that there are many tools with which an investor can build a diversified portfolio. Some of those tools offer risk-reduction relative to equities, some offer return enhancement relative to fixed income, etc.

But for investors to understand the benefits of using an expanded tool kit, they have to start with a goal for the portfolio and then consider how each component helps them achieve that goal. We explore this topic further in a recent article I wrote for Investment Advisor magazine.

Read more in Diversifying Strategies to Defend Gains >