5 Investing Strategies to Protect Your Portfolio

By Michael Shari

Editor's Note: This story has been updated since its original publication in the September issue of Kiplinger's Personal Finance magazine.

A mere two years after the end of the last bear market, another grizzly rout seems to be charging our way. From the market’s April 29 peak through August 10, Standard & Poor’s 500-stock index has plummeted about 17.6% -- just 2.4 points shy of official bear-market territory. And in the week of August 8 alone -- the economically (not to mention thermally) heated week following the U.S’ credit downgrade by S&P -- the Dow Jones industrial average fell 635 points, or 5.6%, on Monday and climbed 430 points, or 4.0%, on Tuesday, only to tumble another 520 points, or 4.6%, on Wednesday.

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Clearly, investors are unsettled and uncertain about the future -- with good reason. Risks abound: Joblessness remains disconcertingly high at 9.1% as of July. Economies in the U.S. and much of the developed world are fragile. And despite the recent Band-Aid that Congress and the Administration slapped on the U.S. debt problem, investors still worry about our extraordinary budget deficits -- not to mention those of countries such as Greece, Italy and Spain.

If the market’s gyrations leave you queasy and you fear that stocks will continue to fall, you may want to play some hard defense. Fortunately, plenty of mutual funds, employing a wide array of strategies, let you do just that. Here are five approaches to protecting your portfolio, listed in order of increasing complexity.

1. Invest with careful stock pickers.

Some plain, old-fashioned stock funds have proven records of outpacing their brethren in tough times. They do this by picking stocks that tend to hold up well in down markets, raising some cash when they have trouble finding bargain-priced stocks (but not enough to be considered market timers), or some combination of the two. The problem with these kinds of funds is that they will almost always suffer at least a bit in periods of stress, and because every bear market is different, they may not do as well in future downturns as they have in the past.

Launched in 1970, Sequoia Fund (symbol SEQUX) has compiled a distinguished record, first under Richard Cunniff and William Ruane, disciples of value-investing guru Benjamin Graham, and more recently under Robert Goldfarb and David Poppe. The fund invests in large, predictable businesses that have a lot of cash on their balance sheets but not much debt -- and thus can weather tough economic times. In addition, the managers let the fund’s cash position expand when they have trouble finding attractive opportunities -- at last report, 25% of Sequoia’s assets were in cash.

Over the past ten years, Sequoia returned an annualized 4.7% through August 10, topping Standard & Poor’s 500-stock index by an average of 3.4 percentage points per year. The fund shone especially bright during the two bad bear markets of the ’00s. In 2008, it lost 27.0%, ten points less than the S&P 500’s decline; in 2002, when the index sank 22.1%, Sequoia dropped only 2.6%. Looking at Sequoia another way, it captured 77% of the monthly increases in the S&P 500 from January 1, 2000, through June 30, 2011, but shared in only 48% of the index’s declines.

DGHM AllCap Value (DGHMX) differs from Sequoia in three notable ways: It’s only four years old, it’s practically unknown, and it stays fully invested at all times. The fund stood out during the last market conflagration, dropping a relatively modest 22.4% in 2008. And private accounts run by the fund’s sponsor, Dalton, Greiner, Hartman, Maher & Co., held up well during the 2000-02 bear market. The accounts, which employ the same bargain-hunting strategy as the fund, essentially matched the S&P 500’s 22.1% decline in 2002 but earned double-digit gains in both 2000 and 2001, down years for the market.

DGHM invests mainly in high-quality, under­valued companies that are leaders in their industries and generate strong free cash flow (the cash profits left after the capital outlays needed to maintain a business). The mutual fund is run by ten analysts, each of whom is responsible for a sector. One of the fund’s earliest and best-performing holdings is Teradata, a digital storage company whose stock has more than doubled since September 2007.

2. Bring some balance to your portfolio.

Balanced funds can cut your stock losses through a simple maneuver: They hold less in stocks. The typical balanced fund invests about two-thirds of its assets in stocks and the rest in bonds. Vanguard Wellington (VWELX), one of the oldest and cheapest balanced funds (annual expense ratio: 0.30%), benefits from an extra dose of an all-too-rare ingredient: common sense. At least a year before mortgage securities started to implode in 2007, co-manager Edward Bousa began selling shares of banks that had stockpiled them. Bousa, Wellington’s stock picker, says he was early to react to anecdotal evidence of homeowners recklessly borrowing more than they could afford -- particularly if housing prices were to fall, as, of course, they subsequently did. As stocks sank in 2008, Bousa bought shares of small, profitable banks -- and watched them soar as the market rebounded in 2009. Recently, he was snapping up energy stocks, which he expects to hold up because global demand remains strong. The fund’s fixed-income manager, John Keogh, invests mainly in high-quality corporate bonds.

FPA Crescent Fund (FPACX) is more flexible than the typical balanced fund. Manager Steve Romick will lower the fund’s allotment to stocks if he thinks the market looks dodgy. He may even sell stocks short, betting on their prices to fall. Romick can invest in companies of all sizes, but recently he has been gravitating to big firms because that’s where he’s finding the best deals. On the bond side, Romick can buy junk and convertible securities as well as investment-grade debt. Crescent, a member of the Kiplinger 25, has captured 84% of the S&P 500’s advances since 2000 but participated in only 40% of its declines.

3. Play the merger game.

Merger arbitrage isn’t as scary as it sounds. When one firm announces that it will acquire another, shares of the target company typically jump -- but not all the way to the purchase price. Arbitrageurs buy after the deal is announced, hoping to earn the final few dollars per share of appreciation between the target’s post-announcement price and the price at which the deal is consummated. Success hinges on picking deals that actually go through, and performance has virtually no connection with the overall stock market.

Merger Fund (MERFX) doesn’t win points for a creative name, and it won’t make you rich during bull markets (it earned a modest 11% in both 2003 and 2006, its two best years over the past decade). But you can’t knock its record of protecting customers during nasty markets -- it lost 5.7% and 2.3%, respectively, in 2002 and 2008. Run by Roy Behren and Mike Shannon, Merger is a member of the Kiplinger 25.

4. Hedge your bets with a hedge-fund-like mutual fund.

An excellent defense against falling share prices is a fund that owns stocks its managers think will gain and sells short stocks they expect to crater. Advisers consider so-called long-short mutual funds safer than similar hedge funds because they are registered with the Securities and Exchange Commission and disclose their holdings quarterly. They are also cheaper than hedge funds, which charge high performance fees.

One of the most intriguing funds in this category is Wasatch Long/Short Fund (FMLSX). Launched in 2003, the fund tends to be heavier on stocks owned than on stocks sold short; at last report, the amount of the fund’s assets in stocks exceeded its short positions by a factor of 5.5 to one. The fund’s performance reflects the tilt toward owning stocks rather than betting against them. It has made money in every year of its existence except 2008, when it lost 20.9%. Managers Michael Shinnick and Ralph Shive take a value-oriented approach in deciding what to buy and what to short, although they also incorporate technical analysis -- the study of price charts, trading volume and other such things -- in deciding what to short.

5. Go all in against the market.

One sure way to hedge against sinking stocks is to buy an inverse stock index fund -- one that’s designed to move in the opposite direction of a particular benchmark. Legions of these funds exist -- for example, Rydex Inverse S&P 500 Strategy (RYURX), among open-end funds, and ProShares Short S&P 500 (SH), among exchange-traded funds. These funds have two fundamental problems: They are guaranteed to lose money when stocks rise, and, because inverse funds can achieve their goals only on a daily basis, results over longer periods may diverge from what you’d expect. Not surprisingly, the Rydex fund excelled in 2008, soaring 40.9%, but it lost 27.3% in 2009, 16.8% in 2010 and 5.4% in 2011 through August 10.

If you want pure insurance for a longer period of time, consider Pimco Stocks­PLUS TR Short Strategy Fund (PSSDX). The fund uses derivatives to establish a position opposite that of the S&P 500. What makes Short Strategy different from the typical inverse market fund is that those derivatives are backed by a portfolio of bonds that are actively managed by the legendary Bill Gross, Pimco’s founder and co-chief investment officer. The fund gained 47.7% in 2008; since then, it has consistently lost less than the Rydex fund -- 14.4% in 2009, 8.9% last year and 1.4% so far in 2011.