Surging indices come with a warning

Add some defense with low-volatility funds

Stock indices have recently surged to record highs. Investors should enjoy the run. But with valuation levels climbing, U.S.-China trade tensions percolating, and geopolitical uncertainty in the Gulf states and the eurozone (with Brexit looming), the likelihood of higher volatility continues to rise.

While some may be tempted to sell all their equity exposure and move into the safety of cash or bonds, the reality is we don’t know when any such downturn in the markets will occur. If we sell out and fail to get back in at an appropriate time, we end up hurting ourselves more than had we stayed invested.

What I prefer to do in such situations is get a little bit more defensive in my equity market positioning rather than get out of the equity markets altogether. This will still allow me to benefit from equity exposure if markets continue to rally but will help protect my capital better in the event of a market selloff.

With that in mind, here are a few ways to position your portfolio in a more defensive way.

Foreign equity. The first thing I would do is to make sure that your foreign equity exposure, particularly U.S. dollar-denominated holdings, is unhedged. The reason for this is that in periods of high market volatility or a big equity market selloff, investors tend to flock to the U.S. dollar. With the U.S. dollar increasing in value, the losses are muted compared with an unhedged currency position.

A great example is 2008, when the S&P 500 fell by 37% in U.S. dollar terms. However, thanks to a sharp appreciation of the U.S. dollar relative to the loonie, the net loss for a Canadian investor with unhedged currency exposure would have been just over 21%.

Another way to help protect your portfolio would be through overweighting or underweighting more defensive sectors. The accompanying table, published by Capital Group, highlights the sectors that have outperformed and underperformed the S&P 500 in a sharp market selloff.

The two sectors that have outperformed most frequently in a market correction have been consumer staples and utilities. In the past seven market corrections, they have outperformed in each. The next best-performing sectors were healthcare and telecom, which outperformed in six of the last seven corrections. Intuitively this makes sense as these sectors tend to deal more in goods and services that are necessities, and are unlikely to be hit as sharply by an economic or market slowdown

For example, consumer staples are items that people are unable or unwilling to cut out of their budgets, evening times of stress. These include such things as food and beverages, and tobacco and alcohol.

Utilities – like power, heating, and water – are things that people need, regardless of their financial situation, and are unlikely to make dramatic changes to their consumption patterns.

Healthcare. If you get sick, you’ll go to the doctor and get what you need.

Telecom includes your phone, be it wireless or old-school landline. While you may look to cut back a bit, they are still largely necessities for most people. Some sectors you’ll likely want to reduce exposure to include industrials, materials, and technology. Typically, these are the inputs to the manufacturing process, and as the market turns, it is highly likely an economic slowdown is on the horizon, which may dampen the demand for such products. Industrials have beat the S&P 500 only once in the past seven corrections, while materials and tech have outperformed only twice.

By overweighting the more defensive sectors, you’re likely to hold up better than the broader markets

A great way to do this is to look at some of the low-volatility funds that I’ve recently covered, such as RBC QUBE Low Volatility Canadian Equity Fund, iShares U.S. Fundamental Index ETF, Horizons Active Canadian Dividend ETF, and TD Global Low Volatility Fund.

By their nature, low-volatility funds tend to be more defensively positioned as they will often build the portfolio based on a measure of risk rather than market capitalization. As a result, more defensive sectors tend to make up a larger portion of these types of funds, resulting in big overweights to consumer staples, utilities, and healthcare.

While this strategy won’t completely protect you against market losses, it has a very high probability of outperforming the broader markets. Furthermore, it still provides you with exposure to the equity markets, which will allow you to continue earning returns and participating in the upside of the market in the event the correction does not occur.

The drawback to this strategy is that if there is no selloff, your portfolio performance is likely to trail the markets, but not nearly as badly as it would have if you had switched all into cash or bonds.

Dave Paterson, CFA, is a money manager and an expert on investment fund research and due diligence on a variety of investment products.

Notes and Disclaimer

Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Mutual funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently and past performance may not be repeated. No guarantee of performance is made or implied. This article is for information purposes only and is not intended as personalized investment advice.