Moves to Consider to Help Protect Your Portfolio & Profits

Moves to Consider to Help Protect Your Portfolio & Profits

By Justin Carbonneau (@jjcarbonneau)

Over the past few weeks, I’ve had conversations with a number of investors about the market’s amazing move higher, the astonishing performance in small caps, cyclicals and some of the areas of the market that seem to be the hardest hit during the economic downturn. Not to mention, the market looks expensive based on most traditional market valuation metrics. While most are happy to see their portfolios significantly higher than about a year ago, some investors are asking about strategies that may help protect some of their profits, and that is what I want to focus on in this article. But before I discuss that, it’s important to understand that anytime there are investment decisions that involve changing parts of a portfolio, there are an implicit set of decisions that may add or detract from returns over different periods of time. For most investors, finding an appropriate asset allocation and rebalancing and adjusting based on your risk tolerance and time horizon is the best course of action. But for those investors that are more active, or have a more opportunistic approach to investing, here are some considerations for how to protect some of your profits in today’s market.

Active Rebalancing & Diversification

Consider an investor that was invested in a 50/50 stocks (represented by the S&P 500) and bonds (represented by the iShares Core US Aggregate Bond index) portfolio at the March bottom of last year. That investor would now be nearly 70% in stocks and 30% bonds due to the fact that stocks have performed so well relative to bonds since then. When you have outsized moved in one asset class over another it can make sense to rebalance more actively as a way to make sure you don’t stray too far from the long-term target allocation that is best given your goals and risk tolerance.

The return map below, sourced from Blackrock, shows just how the major asset classes jockey between positions in any given year. It’s been a great decade for U.S. stocks, nearly doubling the return of the next best asset class in REITs, and a horrible decade for Commodities. The next ten years may not look anything like the last ten years, so diversifying across different asset classes and regions could be the prudent thing to do for those investors looking to protect some of the capital and attempt to get some benefits from mean reversion in the markets and asset classes.

Source: BlackRock Return Map through April 30, 2021

Look at Laggards

Recently my partner at Validea wrote an article about how high-quality stocks have underperformed lower quality stocks and how more high-quality stocks are showing up in value screens. This may present an opportunity. This chart below shows periods of time going back to 2000 where unprofitable companies outperformed profitable companies (i.e., the blue line going down) and when profitable beat unprofitable (i.e., the green line going up). Investors who have benefited from the low-quality stock rally could consider starting to migrate to the higher quality stock category in anticipation of the trend of unprofitable over profitable reversing. International stocks, low volatility stocks (i.e., consumer staples and utilities) and financials are a few of the places in the stock market that haven’t performed nearly has well as the hotter market segments and may be worth considering for those investors looking to shift to parts of the market that may decline less in the event of a downturn or pullback.

Source: “A Value Investor’s View on US Small-Cap Stocks”, Franklin Templeton, Feb. 25, 2021

Hedging and Buffering

Investors that want more a direct play on a decline in the market could look at methodically adding exposure to lower risk asset classes or vehicles that go up when the market goes down such as a tail risk ETF. Given the fact that market timing is typically a drag on returns, these approaches are more likely than not to reduce returns over time, but given the magnitude of recent gains, some investors may be willing to take that risk to protect downside.

There are also some new ETFs from Simplify that invest in the S&P 500, but couple that exposure with out of the money put options. These can offer market upside with some tail risk protection.

The other innovation in the ETF space is buffer ETFs, which are ETFs that can provide investors with some of the market’s upside exposure but take away some of the downside.  For example, the May buffer ETFs from a popular buffer ETF issuer are offering protection against losses of 9%, 15% or 30%.  over one-year and upside caps of 13.60%, 8.62% and 6.60%, respectively. With products like these, some investors may feel comfortable knowing losses are capped and would be willing to give up some of the upside in the market because of this.

Importance of Timing

Many investors who purchased stocks last year in taxable accounts may have, or could be close to, crossing over 12-month holding period where gains become long-term. For those high-earners or ultra-wealthy who may be possibly impacted by the proposed capital gain rate increase laid out by the Biden administration, it may make sense to sell some of the positions where there is the weakest conviction and look to allocate that money to tax efficient strategies like direct indexing or ETFs. This isn’t so much a risk reducing tactic, although it could be, but more so a repositioning for a higher tax regime in the future.

For retirees who withdraw required minimum distributions (RMDs) from their IRAs that are worried about elevated levels in the market, one strategy would be to take the RMD now versus waiting until the end of the year. Due to the CARES Act, RMDs were not required in 2020, and those investors who stayed invested benefited because stocks have come back so much and more or their money was able to compound and recover. It now may make sense to time the RMD a little more aggressively so that you know you are withdrawing the money at lofty levels vs. having to take the money if stocks pullback materially later in the year.

Speaking of retirement accounts, nearly everything I’ve outlined in this article would require either having cash on the sidelines and bringing it into the market or through making changes to an existing portfolio, which may produce taxable gains. However, for those investors where retirement accounts make up significant portion of their investable assets, portfolio adjustments wouldn’t create taxable transactions, which would be a positive for these types of investors.

More than Just Protecting Profits Right Now

So, there are just a few simple ideas on ways to try and reduce the chances of losing a lot in the event of a market sell-off, but that’s not to say these ideas don’t come with their own set of risks, downsides and drawbacks. In general, trying to time when market sell-offs will occur has been a losing proposition. Investing is about trade-offs, but things like rebalancing, diversifying, trying to buy where there is value and paying attention to taxes and withdrawal strategies are timeless methods that investors should be thinking about all the time and not just when the market is at all-time highs. 

Justin J. Carbonneau is VP at Validea & Partner at Validea Capital Management.
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