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Three Funds to Protect Against Market Volatility

These alternative funds offer relief for investors seeking downside protection.

Mallory Horejs,Terry Tian, 08/12/2011

The S&P 500 Index's 16.6% dive between July 22 and Aug. 8 evoked vivid flashbacks of 2008 for many investors. Investor sentiment plummeted and market volatility (as measured by the VIX index) surged to its highest point since May. With the market down 5.7% for the year to date through Aug. 9, a crippling double dip seems more likely than ever before. 

Uneasy investors would be wise to turn toward alternative investments, which seek to provide downside protection during tumultuous market periods, but also positive returns over the long run. These funds employ techniques such as short-selling or hedging, with the intent of generating an attractive long-term risk-adjusted return with low correlation to traditional stock and bond markets. Not all of these funds have performed as advertised, however. The average long-short fund, for example, lost only 7.4% during the recent drawdown (roughly half the market's fall), but hasn't provided positive returns over the past five years. Investors in market-neutral strategies have fared better, with the average fund up 0.5% over the past five years. As with traditional mutual funds, some alternative mutual funds undoubtedly deserve a spot in your portfolio, but not all. Let's take a look at the stand-out performers. 

Merk Hard Currency (MERKX)
Diversifying out of the U.S. dollar is critical for investors who wish to avoid a decline in purchasing power. Not only have recent events called the government's credit-worthiness into question, but most U.S. investors are already overexposed to the greenback through their income stream and portfolio assets, creating a double whammy. An allocation to Merk Hard Currency, one of oldest and largest offerings (five-plus-year track record and $588 million in assets) in Morningstar's relatively small currency category, can help. Manager Axel Merk seeks to profit from the appreciation of developed-markets currencies versus the U.S. dollar by investing in high-quality, short-term sovereign debt instruments. Merk prefers currencies of countries whose monetary policies foster long-term price stability. So far Merk's analysis has been spot-on--the fund's five-year annualized total return and Sharpe ratio (through July) outpace all its peers as well as the S&P 500 Index. Its relatively low 1.30% expense ratio is a bonus. 

The fund has also provided welcome downside protection this year--it's up 6.5% compared with the S&P 500 Index's 5.7% loss for the year to date through Aug. 9. When the market toppled 16.6% over the past two weeks, this fund slid only 1.2%. 

Arrow Managed Futures Trend (MFTFX)
Managed-futures strategies offer investors great diversification benefits due to their near-zero correlations with both traditional stock and bond investments. These strategies seek to profit from momentum across many different asset classes, using systematic, rules-based trading tactics. Unlike other alternative strategies that sacrifice upside potential to hedge downside exposure, managed-futures funds offer the potential for equitylike returns. 

Although momentum strategies often have difficulty navigating oscillating market environments (in 2009, for example), several funds have charted a smooth course this year. One of these is Arrow Managed Futures Trend, which employs a trend-following strategy according to the rules of the Trader Vic Index. Equal-weighted between commodities and financials, the Trader Vic Index calculates momentum based on an exponential moving average (where recent prices are weighted most heavily) that is customized for each futures market sector. Arrow's avoidance of equity index exposure has helped it deliver a 1.9% return for the year to date (through Aug. 9) as well as a 2.0% return during the two-week volatility spike from July 22 to Aug. 8. However, this performance comes at a relatively high price--the fund's 2.00% expense ratio exceeds the category's 1.88% average. 

AQR Diversified Arbitrage (ADAIX)
Market-neutral strategies typically hedge out all market exposure by taking long and short equity positions that offset each other. As such, they strive to provide small but steady returns in all market conditions and can help to stabilize an investor's portfolio during market downturns. Market-neutral funds certainly offered shelter in 2008--the average fund lost 0.3%, only a small fraction of the S&P's 37.0% loss.

Recent performance shows that a handful are protecting investors from market turmoil yet again--the average fund lost 1.5% this past month but has managed to stay in the black for the year to date, at 0.1%. Although Arbitrage (ARBFX) has successfully preserved investors' capital over the past few weeks, it's currently closed to new investors. A good substitute is AQR Diversified Arbitrage, which invests in an array of relative value strategies like merger arbitrage, convertible arbitrage, and other forms of opportunistic arbitrage. Although this fund is slightly down for the year (0.2%), it has still handily outperformed the S&P 500 Index on both an absolute and risk-adjusted basis. Its Sharpe ratio since inception, 2.3, (using weekly data through Aug. 6), is the second highest in the category and more than double that of the S&P 500. On top of that, its 1.20% expense ratio makes AQR Diversified Arbitrage one of the most attractively priced market-neutral offerings. 

Mallory Horejs is an alternative investments analyst with Morningstar.
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