I have previously warned that short ETFs won’t save you in a bear market. In fact, they’re likely to increase your losses.

Buying and holding a short ETF to protect your portfolio from share price falls is therefore a bit like getting a man-eating lion to keep away the wolves.

So what can you do if you fear a falling market? Is there any action you can take to reduce or offset the decline in your stock market investments?

Price falls are in the game plan

First things first: Investing is a long-term endeavour, which requires you to create a plan and stick to it.

If you’re getting nervous because the stock market seems high or vulnerable, you should first consider if taking any action is sensible. Does your plan really involve you making market timing decisions, or valuation calls?

If you’re an active investor – who is willing to risk under-performing the market as a consequence – then you may have decided in advance that you’ll reduce your allocation to equities if the market looks expensive or over-extended by some specific metric. Perhaps you’re watching P/E ratios, for example, or 200-day moving averages.

Passive investors, however, should typically ignore all that, and instead drip feed money in over the long-term, rebalance according to age and asset moves, and ignore pointless prognostication from stock market pundits.

For you, a volatile stock market is to be welcomed. It increase your returns.

If you’ve set up a passive plan and you’re worried, then maybe you’d be better served by a game of tennis, a trip to the cinema, or just generally not looking at your portfolio for a few weeks – or even a few months.

I’m serious! Most people should allocate their money between different asset classes based on factors such as their age, risk tolerance, and their future financial requirements.

Changes after that should be made according to your own pre-determined rules, not rumblings in your stomach.

For example:

• A good reason to sell some of your equities would be that your holding has risen 50%, and now exceeds your pre-determind allocation band. You’re looking to reallocate some of that money into bonds, which locks in your gains, reduces volatility, and brings you back to your original asset allocation.

• A bad reason to sell is because you saw Robert Peston or Jim Cramer on the TV last night, frothing about an economic slowdown. Or because you fear the Russians are coming.

Turning from a passive grin-and-bear-it investor into an active trader just because the market is falling will probably prove a losing strategy.

You get none of the benefits of either approach to investing. You’re arguably even worse than a chump who dives in and out of the markets based on gossip in the pub – because you’re a well-informed chump who should know better.

Ways to reduce risk before a market fall

All that said, if you’re a newish investor and you discover you’re more risk averse than you thought, that is nothing to be ashamed about.

Investing shouldn’t be about emotions, but it definitely involves learning to handle them – and also learning more about yourself as you go.

You get a gold star if you have this revelation after making strong gains – as opposed to getting the fear too late, and deciding ‘to thine own self be true’ once the stock market has dropped 25%!

(In that case, I’d consider trying to be true to somebody else for a couple of years and taking action only after the recovery, rather than selling out at the lows).

Whatever your motivation, if the market feels over-extended and you want to take action, here are some better alternatives to buying short ETFs.

Rethink your asset allocation

Perhaps you’re more nervous about the ups and downs of equities than you anticipated. Maybe you’ve realised a few years of falling stock markets would really ruin your day.

Revisit some model portfolio ideas, and adjust your positions to something less risky, at the cost of less rewarding. Typically this will involve holding much more fixed interest (bonds) and allocating less of your money to equities.

Hold more cash

Don’t dismiss holding more cash to dampen down volatility in your portfolio. Private investors in the UK can get comparatively decent interest rates on cash (certainly compared to government bonds) and while cash clearly doesn’t rise in value like bonds when the stock market drops, it obviously doesn’t fall, either.

It’s also easy to deploy your cash reserves into a falling market, meaning your cash pile can do double-duty as a plunge protection fund.

Sell down your positions

A professional trader once told me that the best way to reduce risk is simply to turn your positions into cash. To sell, in other words.

There’s no feeling quite as nice as “going liquid” when you trade shares. No messing about with options or short ETFs or a pairs-trade.1 Just sell until you feel comfortable again.

Remember Capital Gains Tax. You may be best selling up in ISAs or SIPPS first, depending on your circumstances, since these are exempt from taxes on gains.

Open an offsetting spreadbet or contract for difference (CFD)

This is closer to what semi-active investors are looking for when they stumble across the short ETFs that don’t actually fit their needs.

Here you bet against the index (or a basket of shares) with a carefully-sized spreadbet so that if markets do fall and take your holdings with them, at least you’ll make something back on the spread bet.

You’re basically hedging your portfolio like a long/short hedge fund would.

The advantage is that you’re gaining some downside protection – if the market falls, the value of your bet against it will rise – without having to incur the trading costs of selling your portfolio, nor the potential capital gains.

If you really are a good stock picker, you can even gain if the market goes up, provided your own portfolio rises more than your bet against it.

Remember: This can be very risky. The most you can lose in a traditional share investment is the money you invest, but your losses are unlimited if you short a rising market. Because spreadbetting is tax-free, you can’t offset any losses against capital gains, either.

Read up on sensible spreadbetting before going any further. (A contract for difference is another option, and a whole other post. They are also risky!)

Trade options

Options are the professionals’ way to buy protection. That doesn’t make them a good idea for you or me.

I’ve never traded options. Pricing is non-trivial. Prepare to do plenty of your own research.

Create your own Guaranteed Equity Bond

If you’re very nervous, you might be tempted to invest via an opaque structured product from a bank, instead of putting your money into tracker funds or buying shares.

You might consider creating your own guaranteed equity bond instead.

It’s easy to tweak your DIY GEB to suit your risk appetite, and you’ll know exactly what’s under the hood.

Don’t believe the hype: The reason banks are selling billions of pounds worth of structured products is because they are very profitable for the banks.

It’s not because they’re a good deal for you and me.

Downside risks

All of these alternatives to a short ETF have their own pros and cons, ranging from the potentially substantial frictional costs of trading and taxes, to introducing new types of investing risks.

The biggest risk is the one you’ll hear the least about – that you sell off some or all your shares yet they keep rising afterwards, forcing you to buy back in at a higher price or leaving you with a permanently reduced exposure to equities as you vainly wait for the market to come back.

Markets do rise and fall, but in the long-term most Western stock markets have risen.

Many people wait too late before buying back into a rising market. Academic research suggests that trying to run you portfolio like a hedge fund is a losing proposition for the majority of private investors.

Even the pro fund managers have lost to the simplest tracker combination in recent times. A passive approach with occasional rebalancing will likely do better for most people in the long run.

If you’re going to meddle though (and I write as a meddler) then I think these methods have a greater role to play in sensible investing than short ETFs, which are more like Scooby snacks for day traders.

1. This is where you try to offset one share that falls with another that will go up. You might hold an umbrella maker, say, if you are worried about your big position in a sunscreen manufacturer. [↩]

After getting clobbered for a couple of quarters, our Slow & Steady portfolio has been buoyed up by the new mood of… well, if not optimism, then at least relief that we haven’t been dragged over the abyss by a wounded Europe.

Since we last tuned in:

• The daily doom-mongering over Greece and Italy has faded from the headlines.

• The ECB’s massive money injection into European banks has bought time.

• America has been cheered by a regular flow of positive indicators.

• And (perhaps) recession has been averted (just) in Britain.

All of which has turned last quarter’s 1.70% loss into a 4.69% gain.

Reminder: The Slow and Steady portfolio is Monevator’s model passive investing portfolio. It was set up at the start of 2011 with £3,000. An extra £750 is invested every quarter into a diversified set of index funds, heavily tilted towards equities.

You can read the original story and catch up on all the previous passive portfolio posts here.

Feeling peaky

Here we are then in the second year of our portfolio’s existence. Time flies when you’re compounding interest!

In the first year of its existence, the Slow & Steady portfolio didn’t post a gain higher than the 0.85% we registered in Q2. Indeed, by Q3 we were 9.32% down.

So the new peak hit in Q1 2012 represents a heady moment for our dogged little portfolio. The psychological impact of seeing our numbers turn green is extraordinary, even though the £281.62 we’ve made would scarcely fund a weekend’s jaunt to Tenby.

The human brain just loves a win. We should bear in mind though that if this rally runs out of steam we’ll be heading downward soon enough, and any success so far is born on the back of buying cheap stocks when things are looking dire.

The equity markets that we invest in have risen together over the past three months, and as the Slow & Steady portfolio is aggressively tilted towards equities (78%) their fate is largely our fate.

The US is the powerhouse driving much of the growth, as ever, which shows the benefit of aligning your portfolio with the global market as opposed to trying to predict the future shape of geopolitics using your Risk board.

Our gilt position has slid back a smidge from last quarter (but only a smidge), just as we should expect when the doomsday clock pauses for a few secs. Fixed income still accounts for much of the growth to-date in the portfolio – a sharp contrast to Japan, which has brought in 11p so far.

In other heartening news: we earned some dividends!

Remember that the Slow & Steady portfolio is entirely invested in accumulation funds, which don’t even give us a glimpse of our silver. Instead, these funds automatically use the dividends we earn to buy more shares, so we benefit from the compounding of our wealth over time.

Last quarter’s dividends brought in:

• FTSE All-Share Index: £16.02

• All Stocks Gilts Index: £12.78

New purchases

Every quarter we feed another £750 into the dream-maker / money mincer. The portfolio is still sufficiently small for our rebalancing chores to be achieved via this new cash.

UK equity

HSBC FTSE All Share Index – TER 0.27%
Fund identifier: GB0000438233

New purchase: £138.38
Buy 39.3898 units @ 351.3p

Target allocation: 19%

Developed World ex UK equities

Split between four funds covering North America, Europe, the developed Pacific and Japan.

Target allocation (across the following four funds): 49%

North American equities

HSBC American Index – TER 0.28%
Fund identifier: GB0000470418

New purchase: £160.23
Buy 77.4074 units @ 207p

Target allocation: 26.5%

European equities excluding UK

HSBC European Index – TER 0.31%
Fund identifier: GB0000469071

New purchase: £69.86
Buy 15.6345 units @ 446.8p

Target allocation: 12.5%

Japanese equities

HSBC Japan Index – TER 0.29%
Fund identifier: GB0000150374

New purchase: £29.02
Buy 46.3546 units @ 62.6p

Target allocation: 5%

Pacific equities excluding Japan

HSBC Pacific Index – TER 0.37%
Fund identifier: GB0000150713

New purchase: £26.35
Buy 11.4308 units @ 230.5p

Target allocation: 5%

Emerging market equities

Legal & General Global Emerging Markets Index Fund – TER 0.99%
Fund identifier: GB00B4MBFN60

New purchase: £55.14
Buy 117.5607 units @ 46.9p

Target allocation: 10%

UK Gilts

L&G All Stocks Gilt Index Trust: TER 0.23%
Fund identifier: GB0002051406

New purchase: £271.03
Buy 152.2658 units @ 178p

Target allocation: 22%

TER has gone down from 0.25% to 0.23%.

Total cost = £750.011

Cash = 0p

Total cash = 4p

Trading cost = £0

A reminder on rebalancing: This portfolio is rebalanced to target allocations every quarter, mostly using new contributions. It’s no problem to do as our vanilla index funds don’t incur trading costs.

Take it steady,

The Accumulator

1. We were carrying 5p over from last quarter. [↩]

Plus some good reads from around the web.

Fans of The Accumulator’s articles on passive investing know how hard it can be for UK investors to find information about the various cost components of index tracking funds.

Fund managers can get equally frustrated – at least when it comes to the stats that make them look good!

Now the company behind the fundamental-tracking Munro Fund has created its own resource of statistics to tackle the problem head-on.

Its new website of tracker stats is called Smart-Beta.

The company explains its motivation as follows:

There are now a number of funds, usually described as index or tracker funds, that provide investors with a mechanism to capture the beta of the market in a simple and inexpensive manner. There are also a few funds that seek to deliver the market returns in a different , and arguably better, way than using market capitalisation to determine portfolio construction. It is becoming common practice to describe these as smart-beta funds.

Because these funds use a mix of structures, typically ETFs and OEICS it is hard to find data to make comparisons in one place. It is also difficult to find all the data you need to make a full and proper comparison. It is not much use identifying a low cost fund if the minimum investment is a much larger amount than you wish to invest.

This site has been set up to help address this problem.

The information on Smart-Beta is culled from Bloomberg. Fundamental Tracking Investment Management Limited, the company behind the Munro Fund and Smart-Beta, says data on the site is not comprehensive, and should only be used as a starting point for further research.

It does add though that “every effort has been made to ensure it’s up-to-date”.

[continue reading…]