By Roger Nusbaum, AdvisorShares ETF Strategist
The other day in reaction to our post on gold's role in a diversified portfolio well-known blogger and CNBC contributor, Josh Brown, engaged us in a discussion via Twitter when he asked;
If the world goes to hell, and I have 5% of my portfolio in (NYSEARCA:GLD), how exactly has that helped me?
Our reply over two tweets;
My answer is gold as one of several holdings that tend to not look like equities, reducing extent to which the overall portfolio gets hit may not work the next time but did work before, been saying this many years.
Where the context is whether or not to use portfolio diversifiers like gold, of course gold is not the only choice available, the issue becomes how advisors can effectively use portfolio diversifiers for their clients.
The big idea is that the stock market goes up more often than not, but when it does go down it scares the hell out of clients. During these large declines some advisors will use tools like gold, hedge fund replicators, absolute return, market neutral, funds that sell short or any other products that tend to not look like the stock market to try to spare clients from the full effect of the decline.
The use of portfolio diversifiers is not a static allocation. If stocks go up most of the time then the need for diversifiers lessens during the bull phase of the cycle. During bear phases of the cycle the potential utility of more diversifiers in the portfolio increases. Used effectively, these types of diversifiers can serve to improve risk adjusted returns.
The use of portfolio diversifiers was written about often during the last bear market and now after a five-year rally for stocks the discussion is ramping up again. This past weekend Barron's Fund of Information column explored the use of hedge funds by members of congress as portfolio diversifiers, joking that this might be the only thing that democrats and republicans can agree on.
While no one can know with any certainty when the next large decline is coming we do know that at some point as a function of normal market behavior there will be another very large decline and it will again scare the hell out of clients. And when that occurs, clients will be looking to their advisors to try to protect their portfolios from the full brunt of that large decline.
In general terms, a time to consider increasing exposure to portfolio diversifiers would be after a huge rally in the market. More specifically, a time to consider adding or increasing exposure to portfolio diversifiers would be when the equity market shows signs of price deterioration or a slow rolling over of prices.
Bear markets historically have started slowly over a period of several months not with crashes. Take a look at where the S&P 500 was six months after their respective 2000 and 2007 peaks. According to Yahoo Finance, the S&P 500 was only down 5% six months after its peak in 2000 and six months after the 2007 peak it was only down 7.7%.
After almost five years of market gains it makes sense to start thinking about slowly adding in portfolio diversifiers. Things like gold and hedge fund replicators have helped in the past but of course that is no guarantee they will work in the future but whenever the market does roll over again advisors will want their clients' portfolios to look less like the stock market than it should have in the last few years.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: To the extent that this content includes references to securities, those references do not constitute an offer or solicitation to buy, sell or hold such security. AdvisorShares is a sponsor of actively managed exchange-traded funds (ETFs) and holds positions in all of its ETFs. This document should not be considered investment advice and the information contain within should not be relied upon in assessing whether or not to invest in any products mentioned. Investment in securities carries a high degree of risk which may result in investors losing all of their invested capital. Please keep in mind that a company’s past financial performance, including the performance of its share price, does not guarantee future results. To learn more about the risks with actively managed ETFs visit our website AdvisorShares.com. The article has been written by Roger Nusbaum, AdvisorShares ETF Strategist. We are not receiving compensation for this article, and have no business relationship with any company whose stock is mentioned in this article.