Diversify your portfolio to protect against economic shocks

There's an old truth about investing, which is that we should be most nervous when others all around us are at their most greedy. As equity investors continue to push stock market indices to new highs, more than a few contrarians can be heard muttering from the sidelines that nothing good can come of this rampant optimism.

Hard-money enthusiasts will no doubt be arguing for an ever greater dose of gold within a diversified portfolio. Meanwhile, bond mavericks will start talking up the virtues' of long maturity bonds of, say, ten years or more you can almost hear the tut-tutting of bonds enthusiasts as they warn that "a positive yield of 2% per annum may not sound good, but capital preservation and low yield is a lot better than a potential 10% or 20% equity-market correction".

More free-thinking types, especially those with an adventurous bent, might take a different view and allow for the need for lots of different strategies and not just a reliance on bonds and gold.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Obvious diversifiers

The best protection against anything untoward happening is, of course, to diversify' your mix of assets. Only the most exuberant of optimists would deny that some exposure to bonds or even precious metals might at some stage of an investment cycle make sense.

However, my own feeling is that neither gold nor ultra-safe government bonds are, right now, a great diversifier. Both have their positives, especially after gold's recent fall, yet neither seems to be an optimal' alternative asset, ie, one that offers capital protection plus some upside potential.

There's a whole heap of academic research about the importance of these alternative assets, with the central idea being that you invest a portion of your portfolio in financial assets that move in a different direction (for different underlying reasons) than mainstream equities.

According to academic pointy heads, the best diversifiers have traditionally been either cash or government bonds both of which are negatively correlated (they move in the opposite direction) or uncorrelated (they do their own thing) to the change in price of equities. The problem is that both look spectacularly unappealing at the moment, with yields (and cash interest rates) close to all-time historic lows.

Gold is the other obvious alternative asset of choice (alongside its more precocious sibling silver). However, there's a sizeable school of opinion (to which I subscribe) that holds that gold prices have to expect an even bigger kicking in the short-to- medium term, especially if all this rampant macroeconomic optimism continues unabated, with prices possibly falling as low as $1,000 an ounce.

Alternative alternatives

Luckily there are some alternative alternatives' available via a fund structure that can be easily bought through a stockbroker or an independent financial adviser (IFA). Traditionally, at this point enthusiasts for hedge funds and private equity would start waving their hands around, but we've all collectively learnt a bitter lesson over the last few years, which is that alternatives such as these actually react in a very conventional way to market panic.

Too many hedge funds are, in effect, geared plays on the equity markets, as are private-equity houses, which also suffer from their continued addiction to debt. If I were looking for a true alternative alternative, I'd steer a million miles away from most of these mainstream alternative' fund managers.

That said, I'd also take a discerning view of more sophisticated hedge-fund strategies that, on paper, should deliver positive returns throughout the investment cycle. In particular, I'd be quietly looking to up my (limited) exposure to what are called trend-seeking hedge funds' in the trade jargon rocket scientists who use computing power and clever thinking to catch lots of different trends within the markets, up or down.

This space is usually reserved exclusively for the ultra-wealthy, but there are a few mainstream funds that offer access to this strategy, notably the BlueCrest BlueTrend (LSE: BBTS) closed-end fund. Like many of its trend-following peers, this fund has not had a wondrous few months (actually, a few years if we are truthful), but this is a classic rainy day' outfit if all hell breaks out, and lots of big downwards trends start popping up all over the place, this fund should excel.

Sticking with the hedge-fund theme, I'd also think about the Brevan Howard Credit Catalysts (LSE: BHCG) fund. This small but growing fund can go both long and short (ie, it can bet on rising and falling prices) in all manner of bond markets. It's had some very decent returns of late and my suspicion is that it is ideally positioned for any ructions in the bond markets.

Adventurous types might also be willing to travel much deeper into uncharted waters, in the search for genuine alternative alternatives, ie, financial assets that move to their own rhythm, and in a way that's uncorrelated to equity or even bond markets.

In particular, it might be worth researching the small but growing number of funds that invest in bonds and contracts that pay out in the event of a natural disaster or catastrophe. This is, in effect, a form of reinsurance, but at the stock market fund level rather than through an insurance specialist.

There are two funds on the UK market at the moment that specialise in this opportunity CatCo (LSE: CAT) and DCG IRIS (LSE: IRIS). The first of these funds is a more adventurous option for those willing to take more reinsurance risk for a higher total return (more than 10% per annum) whereas the second (managed by a team at Credit Suisse) is more cautiously structured and is aiming for a return of between 5% and 8% per annum after costs.

These funds are, of course, not without their risks: it is possible that several expensive natural disasters come along at the same time think lots of hurricanes in the US followed by earthquakes, tsunamis and the like in the Pacific Ocean.

Play the boom in litigation

If you are looking for a slightly less adventurous alternative though still very alternative I'd also consider the growing litigation-funding space, currently targeted by two London listed funds, Juridica (LSE: JIL) and Burford (LSE: BUR). These are part of the growing alternative finance' space.

However, they're not overly focused on the higher-risk, sub-prime corporate-bond end of the spectrum rather, they provide funding to individuals and corporates looking to litigate the life out of each other!

My own suspicion is that the desire of wealthy US real-estate developers to sue each other to kingdom come is less dependent on the vagaries of the US business cycle and more on the availability of sensibly-priced options to fund expensive lawsuits. So profitable opportunities abound and hopefully these funds should be able to grind out returns through all but the very worst economic scenarios.

The key question then becomes: who's the best at managing the sector-specific risks? Burford is probably the best long-term bet as there's a sense that the mature Juridica is slowly winding down its portfolio of funded claims. Burford also has a good mix of businesses including a successful UK litigation-insurance operation.

The ability of the fund manager to properly manage risk is the key here, but I'd also be watchful for any future regulatory move to control litigation funding and limit spurious cases.

Protect yourself from sensitivities'

Last but not least, I'd also be thinking about alternative alternatives that insure against some very specific risks not just falling stock markets. Good diversification should always be about insuring your portfolio against nasty macroeconomic outcomes, or "sensitivities" as economists like to label them.

The biggest sensitivity I'd be looking to protect against is a big increase in inflation levels, with the retail price index possibly shooting past a symbolic 6% to 7% level. Shares are, of course, a good protection in some instances for rising prices big companies have real pricing power but that relationship breaks down as inflation rates start to shoot close to double-digits.

It is also not true that gold prices respond in a linear fashion to all instances of rising prices, although they are a traditional inflation hedge.

Bonds clearly have a terrible time during these inflationary episodes, although I think that index-linked bonds and floating interest-rate bonds could be a brilliant idea in such circumstances most government index-linked securities are a terrible buy if you think that RPI will remain below 4% over the next few decades, yet they come into their own if RPI shoots consistently above 5%.

Buyers of corporate index-linked bonds (through a fund such as the M&G Sterling Index Linked Corporate Bond fund or via listed vehicles from Alcentra European Floating Rate Bonds (LSE: AEFS), Carador Income fund (LSE: CIFU) and NB Floating Rate Bond fund (LSE: NBLS) should also benefit as interest rates rise to tame inflation. One key proviso is that default levels might also start shooting up as inflation increases, cutting into total returns.

Peak oil?

My own, admittedly idiosyncratic, take on the inflation risk issue is to buy energy-related stocks a classic contrarian play, given how terribly they've performed over the last few weeks!

I'm no peak-oil bore, but I can't help but be struck by two facts the first is that, after every recession, oil prices keep resetting to higher levels despite the constant discovery of ground-breaking major oil reserves in some part of the planet (last time it was Brazil, now it's the US oil-shale reserves).

The other fact is that energy inflation is a persistent theme in many parts of the world and many consumers have no other choice than to spend a small fortune at the petrol pump and in their utility bills.

That makes me a long-term bull for the major integrated energy majors such as Exxon (NYSE: XOM), BP (LSE: BP), Shell (LSE: RDSB) and Total (NYSE: TOT).

The simplest access, though, is through an energy-sector exchange-traded fund (ETF) tracker like DBX's Stoxx 600 Energy sector fund (LSE: XSER). But don't be under any illusions that these share prices won't still move up and down based on the stock market cycle.