Defensive Allocation Strategies Protect Portfolio Assets in Bear Markets

Defensive Allocation portfolio management vs. buy-and-hold Long-Only portfolio management has always been a mainstay of foundations and pensions but is becoming more accessible to advisors of high net worth (HNW) clients as well. The advent of exchange traded funds (ETFs) has made the offering more enticing since ETFs offer greater transparency, tax efficiency, and low cost. But how do active strategies differ from the long-only style that has been a core strategy of institutions and HNW clients worldwide. First, let us look at the traditional core/satellite offerings to institutions and advisors of HNW clients.  

In order to diversify a portfolio, traditional management techniques centered on Modern Portfolio Theory (MPT), the 1952 treatise of Nobel Laureate Harry Markowitz. MPT states that portfolio diversification could theoretically be determined by asset class selection, thus reducing price variability. A diversified portfolio of stocks, bonds and cash could protect portfolios in market declines. As market volatility increased after 1970, and particularly in the 1990's, foundations and HNW advisors looked to other offerings that were less correlated than the traditional asset classes.  

The present day foundation core/satellite models typically offer: 

1. Managed Futures
2. Private Equity
3. Absolute Return
4. Hedge Funds
5. Long-Only Stocks & Bonds
6. Defensive Allocation

In 2008, most of these offerings did not provide the downside protection that most foundations and advisors were anticipating. The problem was also exacerbated by the illiquidity of managed futures, private equity, absolute return, and hedge strategies, which normally lock up invested assets for periods of three to twelve months. During the financial collapse, investors could not access their moneys before further damage was done. Besides the erratic performance of these strategies over time, they are also expensive, with annual costs exceeding 2% and some with an additional 10%-20% fee above a "high water mark". Defensive Allocation and long-only strategies do not have these fees or illiquidity constraints.  

The long-only, buy and hold strategies also suffered last year as the markets declined. As most advisors know, systematic risk cannot be diversified. So how does the Defensive Allocation strategy differ from the traditional buy and hold long-only strategies? There are two parts to the strategy; the active tactics (offense), and the market neutral tactics (defense). 

Level One Defense: 

The active element of the strategy allows ETF asset selection based upon macro considerations and momentum trend analysis. Asset classes or sub-classes that have potentially strong positive intermediate trends are purchased. Weak negative trend assets that fall below their intermediate (not short term) trading range are sold. The "selling the negative trends" tactic is the first part of the defensive strategy that protects profits and keeps the portfolio from falling into the great abyss that systematically occurs in market dislocations. This process reduces losses that can be extreme at times. 

Level Two Defense: 

The market neutral element of the strategy is the second line of defense. This shorting technique blocks the portfolio from additional downside loss. Legitimate downturns are intermediate in length, thus allowing the purchase of inverse ETFs to first neutralize the core (beta) positions and then the remaining satellite (alpha) positions that remain in the portfolio.  

This two-tiered defensive tactic is the major distinction that separates the defensive strategy from the long-only strategy. Reducing downside risk is critical to the overall long-term performance of any portfolio. 

Macro considerations point to a long repair cycle perhaps similar to that of the 1930s; or the 1966-1982 recession that offered no growth in equities after that sixteen year period. The zigzag returns during those periods were substantial both up and down. In the last 12 months ending September 2009, and the entire bear cycle that started in October 2007, the buy-and-hold Long-Only strategy offered negative returns and severely damaged investor sentiment. Defensive Allocation strategies would have been able to capture much of the upside in the rallies and avoid much if not most of the decline in the downturns.  

The Defensive Allocation strategy works in both bull and bear markets. No one knows how long this secular bear market that started in January 2000 will last. Without the credit markets providing the leverage, along with non-growth policies from Washington, the wait-and-see crowd may take a back seat to the more nimble investor.

George N. Luciani, CFP is President and Chief Investment Officer of Covered Bride Tactical, LLC, a fee only institutional Registered Investment Advisor located in Yardley, PA. (www.coveredbridgetactical.com).