5 Ways to Protect Against a Market Correction

Our eight-year bull market is long overdue for a correction, and investors are starting to look for ways to protect their portfolio from a potential 10 percent or more drop in stocks.

Traditionally, bearish investors sought refuge in bonds, but with interest rates still at historical lows, bonds may not be the "safe haven" they used to be. When interest rates rise, the prices of bonds fall to compensate for their lower yields.

Besides raising rates, the Federal Reserve may put even more pressure on bond prices because it is expected to begin shrinking its balance sheet no later than September, with the European Central Bank not far behind, says Andrew Cowen, portfolio manager of Community Capital Management's Alternative Income Fund (ticker: CCMNX) in Fort Lee, New Jersey. That balance sheet is bloated with bonds that the Fed bought to shore up the credit market during the financial crisis.

"What happens to all rates if the biggest yield-agnostic buyers are no longer in the market, much less shrinking their balance sheet?" Cowen asks. The answer is that investors should look beyond bonds to alternative investments for protection because stocks and bonds may be headed for a sharp drop at the same time.

These investments "smooth the ride" for investors, says Adam I. Taback, head of Global Alternative Investments, a division of Wells Fargo Investment Institute in Charlotte, North Carolina. When stock and bond markets both plummet, ideally your alternatives should remain unaffected – or even rise – thereby helping to buffer your portfolio against losses.

For this to happen, you want alternative investments that are completely uncorrelated to your traditional portfolio so that they behave as differently as possible, says Matt Osborne, founder and CIO of La Jolla, California-based Altegris Clearing Solutions, a talent scout for alternative investment strategies.

When selecting the right alternative mix for your portfolio, keep in mind that these investments don't reduce risk in general but rather "the exposure to certain risk factors," says Deepak Tayal, the former head of risk for Alternative Investments at Oppenheimer Funds in New York. The risk factor you are looking to protect against will dictate which alternative investment you use.

A buffer against rising inflation and interest rates. To protect against rising rates and higher inflation, real estate may be your best insurance policy. "Both property values as well as rents tend to increase faster during periods of rising inflation," Tayal says. Publicly traded real estate investment trusts have outpaced inflation every year between 1974 and 2011, according to an analysis by The Wharton School of the University of Pennsylvania.

In addition to REITs, investors can add real estate to their holdings through private equity or direct ownership in properties. So, for example, investing in commercial real estate debt should provide returns similar to fixed income but with "higher yield and added protection against principal loss," says Evan Gentry, CEO and founder of Money360, a commercial real estate marketplace lender in Ladera Ranch, California.

The problem with investing directly in real estate is that your money is often tied up for a long duration. At Money360, investors use bridge loans as a shorter-term option. "By investing in commercial real estate debt, such as one-to-three-year bridge loans, [investors] can use the short duration to hedge against interest rate risk - you're not locked in for five or 10 years if rates rise - and the underlying collateral to protect against principal losses," Gentry says.

The cure for panic-selling. Research has shown that private equity has outperformed public equity with lower volatility over a long period, Osborne says.

Because there isn't a daily market for private equity, investors can't always sell these investments when they want to, but they do earn a "liquidity premium" in exchange for forgoing access to the funds. Restricted access prevents investors from panic-selling, which frees the investment manager from having to keep cash on hand for unplanned redemptions.

Private equity often requires a high minimum investment, typically between $100,000 and $250,000, although some private equity mutual funds have lower minimums. The Altegris KKR Commitments Fund, for example, has a $25,000 minimum and invests primarily in buyouts of small-, mid- and large-capitalization companies with established cash flow. Investors buy shares of the privately held fund directly from Altegris. Private equity mutual funds carry high expenses ratios often above 2 percent. Fees for the Altegris fund range between 2.12 and 2.82 percent depending on share class.

A way to offset a down market. Hedge funds give investors "the ability to short out market exposure," Taback says.

Hedge funds with a net short position tend to increase in value during market downturns, says John Sedunov, an assistant professor of finance at the Villanova University School of Business in Villanova, Pennsylvania. "However, these types of funds don't typically perform well during bull markets, so investors may only want a small piece of their portfolio dedicated to [them]." He says to consider volatility-based hedge fund strategies for protection in a bear market, as volatility tends to increase then.

With any style of hedge fund, keep in mind that the fund's success is closely tied to the skill of the fund manager. As with private equity, hedge funds can be highly illiquid.