Many investors and economists are anticipating a recession ahead, although predictions vary widely as to its timing and severity. It stands to reason, however, that the upcoming election and ongoing economic uncertainty will lead to prolonged stock market volatility, if not a bear market. In times like these, we’re all thinking about methods for protecting client portfolios in an economic downturn. Here, to help you think ahead, my colleague Tom Scarlata and I review current asset allocation strategies to consider.

Active Management

With this strategy, the portfolio manager selects a balanced mix of investments and assets that’s designed to manage risk while meeting the investor’s goals. Of course, unpredictable market risks will affect the portfolio, but the idea is that if one sector is down, another will be up, thus mitigating damage to the client’s capital. You might say that the active management approach correlates to the adage “win by not losing.”

It’s clear that choosing the right portfolio manager is key. You may wish to consider a manager’s track record, including how he or she performed in the last bear market. Although past performance does not guarantee future results, it can help you understand the manager’s decisions and provide a benchmark for performance against the market. Ten-year performance figures are insufficient, as they don’t include 2008, so you’ll want to go back to 2007 (the last peak before the global financial crisis) to really get a sense of how the manager operates.

In addition, a review of the following performance measures may be helpful:

• The 13-year downside capture ratio, which tells you how much an investment loses in relation to the overall market’s loss during a bear market

• The beta coefficient, which measures the volatility of a stock or fund compared with the market as a whole

• The Sharpe ratio, a measure of risk-adjusted performance, which indicates if returns come with too much additional risk

Low-Volatility Investment

Another strategy for protecting client portfolios is factor investing. This approach, which targets broad factors recognized for driving persistent returns, has become popular in recent years, particularly in the form of low-volatility exchange-traded funds (ETFs). This type of fund seeks to deliver lower volatility than a benchmark fund or index. In theory, these funds should fall less than the overall market in bad times, with the corollary that gains may be lower in a rising market. As such, the dozens of available low-volatility ETFs can be viewed as attractive ways to gain exposure to stocks that exhibit more stable performance.

Two well-established indices that ETFs track include the following:

• MSCI USA Minimum Volatility Index: This index measures the performance of equity securities in the U.S. that have lower absolute volatility. It relies on statistical correlations that keep the portfolio from being too heavily weighted in single sectors or securities.

• S&P 500 Low Volatility Index: This index comprises approximately 100 stocks from the S&P 500 that have had the lowest daily volatility over the past year. Its methodology does not consider correlation, so the stocks held may simply have the lowest historical deviation from the S&P 500’s average rate of return.

Dividend Investment

Dividend-paying companies are often more stable than companies that don’t pay a dividend, so these strategies may be worth considering. When markets decline, the dividends, which often account for a significant portion of a stock’s total return, can help provide an additional layer of downside protection and reduced volatility.

Fixed Income

Fixed income can play an important role in downside risk mitigation, as the asset class aims to fulfill a dual role of preserving principal while generating stable returns. Fixed income can generate positive returns across different market environments, especially when equity markets pull back. The benefits of allocating to this asset class are not limited to down markets, however. A fixed income strategy can help provide steady, low returns with limited volatility in positive markets, too.

Various factors influence fixed income performance—including time until maturity, sensitivity to interest rates, inflation risk, and liquidity—which can make trying to time returns difficult. Likewise, different fixed income asset classes carry different levels of risk. Still, fixed income has long been the ballast in investors’ portfolios. Maintaining a consistent allocation of fixed income assets can help prepare a portfolio to better withstand turbulent markets.

Alternative Investments

Alternatives can bridge the gap between traditional equity and fixed income allocations. Alternative strategies typically play the role of diversifier within the portfolio, with the goal of adding additional return while limiting volatility. These strategies include:

• Shorting: Arguably, the best-known alternative strategy is to “short” an investment or bet against it. Using long/short equity funds, a manager can build a traditional long portfolio and then implement either individual position or index shorts that aim to generate positive returns and downside protection if equity markets struggle.

• Tactical allocation: Tactical allocation strategies take advantage of strong market sectors or changes in asset pricing. They use an array of derivative investments, as well as long and short positions on securities. Although it sounds risky, tactical allocation has two main benefits. First, the methodology is strategic; the investor doesn’t have to decide when to be in equities, fixed income, or cash. Second, much like fixed income, tactical allocation aims to limit volatility and drawdowns through a variety of strategies.

Alternative strategies can offer greater upside potential than fixed income; however, the unique methods they employ can result in a portfolio allocation that looks drastically different from when it was purchased. So, be sure you and your clients know what the portfolio owns at any given time, as well as how it’s built.

Putting It All Together

We’ve discussed a few strategies within each asset class, but downside protection can also be obtained through traditional asset allocation adjustments or rebalancing strategies. Equities have been on quite a run, so it’s important to realign your portfolios with your clients’ risk tolerances. A reduction in equities and a shift toward a more conservative model could help protect capital in a bear market.

If your asset allocation strategies are where you want them, look at each piece of the puzzle to see how volatility can be reduced. While we can’t predict exactly when the next recession will hit, understanding the product landscape within each asset class and how certain strategies can reduce volatility will help your efforts toward protecting client portfolios.

Investments are subject to risk, including the loss of principal. Some investments are not suitable for all investors, and investing in alternative investing involves special risks, such as risk associated with leveraging the investment, utilizing complex financial derivatives, adverse market forces, regulatory and tax code changes, and illiquidity. There is no assurance that any investment objective will be attained.

Exchange-traded funds (ETFs) are subject to market volatility, including the risks of their underlying investments. They are not individually redeemable from the fund and are bought and sold at the current market price, which may be above or below their net asset value.