Hedging Against a Downturn

June 14th, 2012
in contributors

Article of the Week from Investing Daily

by Guest Author Ben Shepherd

roller-coasterSMALLTwo months ago, I interviewed Kevin Mahn, president and chief investment officer at Hennion & Walsh Asset Management, for Benjamin Shepherd’s Wall Street. He spoke at length about his outlook for the global economy and the geographies and asset classes he favored in such an environment. Thus far, much of his forecast has been borne out, though he didn’t expect the market’s recent swoon to occur until the second half of the year. He also offered solid advice on portfolio construction and hedging strategies that should help investors steady their portfolios if the market suffers more downward volatility in the months ahead.

Follow up:

What are your expectations for the US market this year?

I characterize my outlook for 2012 as riding out the “U.” This U-shaped economic recovery will unfold more slowly than many previously thought. The first half of the year will be marked by modest growth and mounting optimism. The performance of the market and the economy in the second half of the year will hinge upon a resolution to the European sovereign-debt crisis and greater clarity as to the outcome of the current US election cycle.

When I say modest growth, I mean that in two senses. From the perspective of economic growth, gross domestic product (GDP) should grow between 2.4 percent and 2.8 percent, which is below average for economic recoveries. From the perspective of the stock market, the S&P 500 could gain between 4 percent and 8 percent this year.

Although the market for residential real estate appears to have finally bottomed, we’ve yet to see convincing evidence that a recovery in the housing market is finally underway. Real estate accounts for somewhere between 20 percent and 60 percent of the average household’s net worth. If homeowners are concerned that the value of their property will remain depressed or decline even further, then that will continue to restrain consumer spending.

Most consumers and businesses are still in the process of deleveraging, which means additional spending is unlikely to happen until they finish paring debt to manageable levels. As such, I suspect that the consumer spending increases that we saw in December won’t be sustainable in 2012.

Any thoughts on how the European sovereign-debt crisis will ultimately be resolved?

It all depends upon Germany, whose financial strength makes it the key player in any resolution. If Germany pledges the necessary capital to stabilize the European banking system, then perhaps Europe will finally emerge from this debt crisis. Longer term, defaults are likely in Greece, Spain and Italy. Beyond that, the euro may no longer exist five years from now, with some eurozone countries reverting to their original currencies.

Although we’re hesitant to invest in Europe, there are some emerging markets that offer opportunities for above-average growth.

In Latin America, Brazil and Columbia have growing economies. And Brazil’s economy should get a boost as it prepares to host the 2016 Summer Olympics. In the Middle East, Turkey and Egypt offer opportunities for above-average growth. In the Far East, countries such as Indonesia and China are attractive.

China has been faulted for its inability to perpetuate the exceptional levels of growth the country has experienced in recent years, but their economy will still likely grow between 8 percent and 9 percent this year. By comparison, the US economy is forecast to only grow around 2 percent this year. If China is able to successfully engineer a “soft landing” for its economy, then that not only benefits the commodities market, it will also be a boon for the numerous US companies whose growth increasingly depends upon Chinese demand.

Some analysts have said that China’s demographics could prove a long-term challenge for China. What’s your take?

China has ample cash and a strong market, so they can slow inflation and still grow their economy. But their demographics could be a concern.

One impact of China’s one-child policy is that it’s created a bell curve in terms of the nation’s aging population. That’s raised the question of whether the younger generations can provide a sufficient workforce to grow the economy while meeting the demands of an aging population. So I think they’re at an important inflection point in terms of how they manage their economy and how they manage their society. But it’s difficult to argue with China’s 8 percent annual GDP growth and the size of their overall balance sheet.

Speaking of demographic changes, won’t the fact that many baby boomers are beginning to retire help reduce our unemployment rate?

Employment statistics show that 20- to 30-year olds are actually the largest unemployed demographic at the moment. That raises the question of whether they possess the skills and experience to replace that aging population or whether those jobs will ultimately be phased out.

If jobless claims start climbing again, that’s going to make the 92 percent of Americans who are currently employed wonder if there’s a potential pink slip in their future. If they’re concerned about their job security, they’re going to be less likely to spend and more likely to hoard cash, which is exactly what this economic recovery doesn’t need.

However, if jobless claims remain steady or even slightly decline, working Americans will become more optimistic and start to spend again.

There’s still quite a bit of political turmoil in the Middle East, particularly in Egypt. Why is that one of your favored geographies?

In 2011, emerging markets suffered heavy losses. Emerging markets typically benefit the most from incremental increases in economic growth following major downturns.

In the Middle East, there’s a great deal of uncertainty with regard to Iran’s nuclear ambitions and how North Korea’s new leader might contribute further to proliferation in the region. In Egypt and Turkey, however, the data suggest that their economies are stronger relative to their regional peers, absent the political turmoil.

Of course, we are far more confident about economic growth in Latin America and the Far East. So if I had to rank our favorite geographies by order of preference, I would list Latin America first, followed by the Far East and then the Middle East.

Which asset classes should investors favor?

This year, our highest conviction forecast is for a US economic recovery that grinds along with modest GDP growth. US companies will post record earnings and maintain strong balance sheets, but will still be reluctant to ramp up spending. However, consumer confidence and spending should rise toward the latter part of the year when greater clarity regarding the aforementioned situations in the US and Europe remove uncertainty from the market. We assigned a 60 percent probability to that outcome.

However, we also assigned a 25 percent probability to a scenario in which US GDP growth exceeds 3 percent on an annualized basis, the European crisis is resolved sooner than expected, and the outcome of the US election is apparent earlier in the year. In that scenario, the US stock market could return between 15 percent and 20 percent.

If you sum the probabilities for each of these two scenarios, there’s an 85 percent probability that the market will produce a positive return in 2012. As such, I’ve given equities a greater weighting in our asset allocation strategy this year, with a particular emphasis on larger-cap stocks. For the first half of the year, we favor dividend plays. However, as we move toward the second half of the year, growth strategies will trump value-oriented and dividend strategies.

We use certain emerging market equities and fixed-income securities as a hedge against volatility. We also find alternative asset classes compelling, such as real estate investment trusts (REIT) as well as precious metals, agricultural and energy-based commodities.

Because traditional asset classes have become so closely correlated, we have to delve deeper into those asset classes to discover attractive plays and consider more alternative asset classes when building portfolios.

What do you think of gold as an asset class?

Despite gold’s volatility, financial advisers are increasingly using the yellow metal as a safe haven instead of US Treasuries.

Like other advisers, we do have allocations to precious metals in our portfolios. While the weightings we’ve assigned to precious metals are not as great as in years past, we still think they have a place in most investors’ portfolios. We generally like to use exchange-traded funds (ETF) that hold a basket of precious metals because we think it’s often an exercise in futility to try to select the particular metal that’s set to outperform.

How should investors approach sector allocation?

Last year’s market laggards have become this year’s market leaders. In 2011, sectors such as utilities, health care and consumer staples led the way. This year, the financials, technology and energy sectors are outperforming. But this trend may not persist because there could be more volatility ahead.

Still, investors will likely gravitate toward defensive sectors that pay solid dividends and have strong balance sheets until there’s more certainty in the market. They remain skeptical about the market’s prospects after enduring last year’s trendless volatility. Although consumer-defensive and value-oriented strategies are appropriate for now, investors will want to pursue more cyclically sensitive areas once businesses and consumers start to spend again.

What’s your best advice for investors?

Investors should team with an adviser who can help them build a portfolio that’s tailored to their risk tolerance. They should also look beyond traditional asset classes and consider alternative asset classes. ETFs as well as passive and active strategies should be used to build a comprehensive portfolio that can weather downside volatility, while also participating in the market’s upside. Once you’ve set your asset allocation strategy, review it on a quarterly basis and make tactical adjustments as necessary. Unfortunately, a static portfolio strategy no longer works in this volatile market.

What’s New

Last week, Exchange Traded Concepts–a relative newcomer to the exchange-traded fund (ETF) industry–launched its second fund, AlphaClone Alternative Alpha ETF (NYSE: ALFA). The new fund becomes one of 13 exchange-traded products that aim to replicate the strategies and returns of hedge funds.

The AlphaClone Hedge Fund Long/Short Index has been designated as the ETF’s benchmark index and its goal is 100 percent replication. In order to create the index, the firm analyzes Securities and Exchange Commission (SEC) filings made by hedge fund managers and other institutional investors and assigns each fund a “clone score,” which helps assess those strategies that perform best when replicated.

Positions held by the highest ranked managers are then included in the index and weighted according to the number of managers holding the stocks. Technically, the index is equally weighted, but positions held by multiple managers could receive as much as a double weighting.

This approach to portfolio construction is unique in this niche. Most ETFs that attempt to mimic hedge fund performance seek to do so by mirroring the beta–the expected volatility–of their benchmarks, rather than the underlying holdings of the hedge funds themselves.

One complication, however, is that hedge funds typically report their holdings to the SEC with a significant lag. That means hedge fund managers may have already abandoned some of the positions listed in their filing by the time their disclosure is made public.

Another interesting feature of the fund is that the methodology used by its underlying index allows for a great deal of flexibility in hedging. When certain market volatility thresholds are met, the fund can swing from being 100 percent long to as much as 50 percent short.

AlphaClone Alternative Alpha ETF is fairly expensive relative to its peer group, with an annual expense ratio of 0.95 percent. It remains to be seen whether the ETF can deliver superior results to justify that price tag.

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