Four Ways to Protect Against the Debt Ceiling
Investors used to navigating their way around Wall Street now have Washington to contend with as well, creating a need to guard against a plethora of political uncertainty.
Though lower this week, financial markets have climbed higher since Congress avoided the perils of the "fiscal cliff" by agreeing to a stop-gap measure avoiding the worst of tax increases and spending cuts.
But with that obstacle off the table for now, another one has emerged: The specter of running into a debt ceiling that would bring much of the government's operations to a halt and cause chaos in the economy. (Read More: Debt Ceiling Battle: Why No One Agrees on Anything)
Cautious investors, then, are turning to innovative ways toward portfolio protection in case a debt ceiling impasse creates increased market volatility, which is extremely low now. The government is expected to hit its borrowing limit within a month or so. At the same time, a related battle over automatic spending cuts, called "sequestration," also looms.
"Everyone should have a safe-haven side of the universe in their portfolio, regardless of how you're thinking about what will happen," said Jim Paulsen, chief market strategist at Wells Capital Management. "You still own some Treasurys, you still have exposure to the dollar, you're still in large-caps, with some gold exposure. Even if you have them underweight, they're still in your portfolio."
But it's not only those traditional forms of protection. Investors are using some other less well-known methods as well.
Here are four of them:
Flying With the Black Swans
Investors are always looking for the black swan - that unexpected event that can roil the markets, such as the subprime mortgage crisis or the Long Term Capital Management crisis of the late 1990s.
Bond giant Pimco even has a fund tailored specifically toward improbable events, sometimes referred to as "fat tails" for their placement at the far reaches of the traditional bell curve of possibilities.
The Global Multi-Asset Institutional Fund, with $5 billion in assets, is popular among portfolio managers looking to give their clients cover during turbulent times.
"If the hedge becomes necessary we will be minimizing our losses," said Michael Kresh, president of M.D. Kresh Financial Services, a boutique retirement planner in Islandia, N.Y. "We hope you never need the insurance, but the good news is if you need it you have it." (Read More: Why Stock Market Is 'Going to Hit a Brick Wall')
The fund is rated four stars by Morningstar and has returned more than 9 percent year to date, easily outdistancing the Standard & Poor's 500. Component-wise it blends 60 percent to the SCI World Index and 40 percent of the Barclays Capital U.S. Aggregate Index.
"We must be prepared because there are too many different ways of screwing things up" in Washington, Kresh said.
Swimming With the Whales
Who better to know their way around a crisis than a whale - a Wall Street whale that is, someone known for investing prowess in the face of danger?
Replicating the moves of hedge fund titans with historic records is part of an increasingly popular strategy known as "cloning." It entails constructing funds that look at where guys like Bill Ackman, Jim Chanos and David Einhorn put their money, and following their lead. (Read More: Activist Investor Dan Loeb Takes 8% Stake in Herbalife)
"For us the cool thing about what we do is we don't pick stocks, we pick managers," said Maz Jadallah, CEO of AlphaClone. "We develop rules around our portfolios in the case of really large events that span multiple months, to protect capital."
Jadallah runs the AlphaClone Alternative Alpha exchange-traded fund, which uses a proprietary system that traces 13f regulatory filings of big managers. The fund, which is not yet a year old, is up 4 percent year-to-date.
The criticism against following 13f reports is that they are backward looking, so the investments they contain may have been sold by the time the reports are filed.
But Jadallah said the managers he tracks show histories of staying in positions for long periods - usually a year or more.
"These guys are waiting a long time to realize the theses that they're invested in," he said. "The filings can be a valuable source of investment decisions."
A broader approach to crisis investing involves limit orders - pre-setting what you'll buy and sell depending on stock performance.
That allows investors to make sure they get in at a good price if a stock declines and provides consistency to decision-making for those who believe that any market dips will be temporary.
"It helps me to take back control in a highly volatile environment," said Mitch Goldberg, president of ClientFirst Strategy in Dix Hills, N.Y. "Any number of black swan events can hit us at the same time. So I want my buy-limit orders in place ahead of that to take advantage of the volatility. The reason I like the limit order is it instills discipline."
Limit orders - where to buy and where to sell - can vary by sector. Goldberg said he'll use a wider range of buy-sell limits for cyclical sectors like industrial stocks than he will for defensive areas such as consumer staples or health care.
"I'm not fully invested, but I plan on getting fully invested based on whether the market dips, and I'm always expecting the market to dip," he said. "Even when I'm a raging bull I am still preparing for dips."
Buy Right With Buy-Writes
The buy-write options strategy is also one that has been out there for a number of years but is gaining popularity.
The maneuver involves buying a stock and then selling a call option against it, allowing the holder to profit on the sales of the call so long as the option remains below the strike price. Losses, then, are minimized to only the difference between the purchase price and the options target should the stock rise.
The buy-write strategy can be accomplished either with individual stocks or indexes.
For investors who are shy of options, there are ETFs they can use that replicate the strategy.
"We wanted to construct a portfolio that can articulate that point of view and that asymmetry, taking the common buy-write and putting volatility as its main component from the risk-reward standpoint," said Eric Metz, portfolio manager of the RiverNorth fund, which started trading in October.
Metz said the fund looks for "mispriced volatility" among individual stocks. Technology and financial services are the largest sector components among its holdings.