Investors find ways to deal with rising risk in stocks and bonds

Most people were reluctant to say it out loud until recently, but a growing universe of investors has begun to see that risk is real and rising across both the stock and bond markets. That recognition raises the question of what to do with portfolios.
Monday, LPL Financial chief market strategist Jeffrey Kleintop answered the call to risk aversion in bonds with a list of four alternatives to traditional bond allocations. In what he described as a means of managing the higher interest rates that could come with faster economic growth, Mr. Kleintop highlighted bank loans, business development companies, real estate investment trusts and master limited partnerships.
Each strategy has some diversifying components designed to help reduce risk of long-only strategies.
Perhaps the most interesting part of the LPL recommendations is that they direct investors toward a universe of fixed-income proxies, well beyond just chasing equity dividend yields for alternative-income streams.
The MLP space, for example, represents a “key beneficiary of the American energy renaissance,” according to Mr. Kleintop.
(Don’t miss: Why invest in North American energy, and why now?)
Pipeline operators posted single-digit gains yields last year and the category’s 27.6% total return nearly kept pace with the 32.4% gain by the S&P 500.
But even as strong performance is nice, the emphasis at times such as these should be on diversification, which often means giving up some performance in exchange for protection.
“The conventional wisdom has been that the only way to reduce risk in a portfolio is to buy bonds, but the truth is that there are equity strategies that offer less risk than bonds and these strategies can be quite effective in an asset allocation in achieving desired returns with less risk that the market overall,” said Harry Merriken, chief investment strategist at Gateway Investment Advisers and manager of the $8.2 billion Gateway Fund (GATEX).
Last year was the second consecutive year that the fund has grown by more than $1 billion.
The growth is especially impressive when one considers the fund is designed to capture at best about half the performance of the S&P.
The fund strategy employs put and call options on a portfolio of about 250 stocks that are managed as a proxy for the S&P 500. The fund’s total return is enhanced through the sale of one-, two- and three-month call options, while the downside is limited through the purchase of put options.
Since the start of the year, the fund has declined by 1.3%, in line with the Morningstar long-short category average, and compares with a 2.4% decline in the S&P.
Last year the fund gained 8.4%, while the S&P gained 32.4%.
But the fund’s last down year was 2008 when it lost 13.9%, compared with the S&P’s 37% drop.
What investors of the fund appear to appreciate is the smoother ride that can be measured in the form of standard deviation.
Over the past 25 years, the fund has generated an annualized return of 7.4% with a standard deviation of 6.8%. That compares to a 6.9% annualized return for the Barclays U.S. Aggregate Bond Index, which had a less volatile standard deviation of 4.1%. The S&P, over the same period, averaged 10.5% with a standard deviation of 15.8%.
“The recent selloff in the market strengthens the case for having a hedged portfolio,” Mr. Merriken said. “Bonds are not without risk since they carry credit risk and this year, bonds will likely face interest rate increases, thus putting pressure on their prices.”