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bonds

Investments to Replace Bonds in Your Portfolio

If you're looking for safer diversification after the fallout from Brexit, check out these options.

The big drop in world markets after the United Kingdom’s shocking vote to leave the European Union is only the latest reminder that investors need a variety of eggs in their portfolio baskets. Large caps, small caps, Asian stocks, European stocks, high-yield bonds, oil, copper—practically everything took a dive. The same happened in 2008. Not only did large-capitalization U.S. stocks lose 37% of their value, but real estate, commodities and foreign stocks tanked as well. Real diversification demands assets that don’t move up and down in tandem.

You need a strategy for softening the impact of market setbacks. Using hedging strategies will usually produce slightly lower returns over the long run, but, in my view, the smoother ride you get in return is worth the cost. I would be happier with a 6% return year after year than a 25% gain one year and a 10% loss the next.

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The traditional wisdom for hedging a portfolio is to buy bonds to temper the ups and downs of stocks as well as provide consistent income. Medium- and long-term Treasury securities, with maturities ranging from, say, seven to 15 years, have thrown off interest of about 5% annually over the past century, with no risk of default. So a portfolio with half of its assets in Treasuries and half in a diversified bundle of U.S. stocks has produced long-term returns averaging about 7.5% annually. Even better, in no 10-year period over the past 90 years has such a portfolio ever lost money, according to Morningstar.

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Investors, however, face two big hurdles: Bonds today are not paying 5% interest, and U.S. stocks seem unlikely to match their long-term average return of 10% per year. The 10-year Treasury is yielding 1.49%. If you believe stocks will return a few percentage points per year less than they have in the past, a 50-50 portfolio will, on average, return less than 6% a year.

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There is, however, another solution. You can substitute alternative investments for some of your bond holdings. An alternative is an asset class that moves out of sync with the stock market. One popular example is gold. On June 24, the day the outcome of the U.K. vote to leave the EU became known, SPDR Gold Shares (GLD, $126), an exchange-traded product that tracks the price of the commodity, rose 4.9%, while SPDR S&P 500 ETF (SPY, $209), which tracks Standard & Poor’s 500-stock index, fell 3.6%. In 2008, when the S&P 500 ETF plunged 36.8%, the Gold fund gained 5.0%. In 2013, when the stock market ETF soared 32.2%, the Gold fund sank 28.1%. (Prices are as of June 30.)

Gold and stocks sometimes move together—as in 2009, 2010 and 2012—but, generally, they orbit different planets. Although I’m not a fan of gold, it is clear its meanderings aren’t determined by the same forces that move stock prices.

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Shift to neutral

Another example of an alternative investment is the market-neutral fund, whose manager tries to take market risk out of the picture by constructing a portfolio that balances long and short positions. Longs are simply traditional stock purchases, made in the hope that prices will rise. When you go short, you borrow a stock from someone else, sell it immediately, and then hope it declines in value so you can buy it back and return it when it’s worth less—and pocket the difference.

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In a market-neutral fund, a manager may go long with one stock and short with another one in the same sector, making a profit if the long does better than the short. For example, a manager might decide that Coca-Cola (KO) is superior to Pepsico (PEP). She buys $1 million worth of Coke stock and shorts $1 million worth of Pepsi stock. Over a year, let’s say that the overall market is up, and Coke rises by 20%, but Pepsi increases by just 5%. The fund makes a $200,000 profit on Coke stock and suffers a $50,000 loss on Pepsi stock, for a net gain of $150,000, not including dividends. What if the overall market falls? The fund can still make money as long as Coke outpaces Pepsi. Say that Coke declines by 10% but Pepsi drops by 25%; then the fund will lose $100,000 on Coke but make $250,000 on Pepsi, for a net gain of $150,000.

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Market-neutral strategies are typically the province of highly paid hedge-fund managers. Some of the best public mutual funds in this sector require lofty minimum investments and charge high fees. Vanguard charges just 0.25% a year for its Market Neutral Fund (VMNFX), the lowest fee of any mutual fund in the category, but it requires an initial minimum investment of $250,000. (The 0.25% figure excludes extra costs involved in selling short.)

Otherwise, the pickings in this category are slim. Among no-load funds with reasonable minimums, the best by far is TFS Market Neutral (TFSMX), which requires a minimum investment of $5,000 and has an expense ratio of 1.9% (excluding short-selling-related fees). Over the past 10 years, the fund, which focuses on small-cap stocks, has returned 3.9% annualized. Since 2008, the fund’s calendar-year returns have ranged from –7% to 17%, suggesting relatively low volatility, the hallmark of a good market-neutral fund. By contrast, the range for SPDR S&P 500 ETF was –37% to 32%.

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Also consider the approach of the Merger (MERFX) and Arbitrage (ARBFX) funds to alternative investing. Each buys shares of already-announced takeover and merger targets, with the goal of capturing the last few percentage points of appreciation between the post-announcement share price and the price at which the deal is consummated. The result is modest, bond-like performance that is utterly divorced from the overall stock market and that exhibits little volatility. In 2008, the annus horribilis for stocks, Merger was down 2.3%; Arbitrage fell 0.6%.

Finally, you can invest in companies whose business is relatively isolated from the economy as a whole. One prime example is reinsurance. Property-and-casualty insurers don’t want to bear the entire risk of shelling out payments after a catastrophic event, such as a huge hurricane, so they buy their own insurance from reinsurers. The performance of such companies depends, in large part, on the frequency of major natural disasters—events unrelated to the stock market.

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Warren Buffett is a longtime fan of the business. His company, Berkshire Hathaway (BRK.B, $145), owns Gen Re, one of the largest reinsurers. Berkshire is broadly diversified, with holdings that range from jewelry retailing to banking to consumer goods. But, with the exception of 2008, Berkshire’s annual returns have diverged nicely from those of the S&P 500 over the past decade.

For a purer play on the reinsurance business, consider Renaissance Re Holdings (RNR, $117). Its stock’s returns have diverged widely from those of the S&P 500 practically every year—by more than 15 percentage points in five out of the past 10 calendar years. Its volatility is much higher than that of a merger or market-neutral fund, but so are its returns, which have averaged 10.2% per year over the past decade. Others worth a look are Third Point Reinsurance (TPRE, $12), a smaller firm that was launched only five years ago but benefits from experienced management, and Validus Holdings (VR, $49), which has a superb record and sports a 2.9% dividend yield.

Got it? Buy insurance companies for your own insurance.

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