By Christopher Dhanraj, Head of ETF Investment Strategy, BlackRock.

Christopher Dhanraj, Head of ETF Investment Strategy, BlackRock.

While the 2019 market rebound has undone much of the damage from 2018’s year-end drubbing, the brutal selloff offers a key reminder for investors about portfolio management, specifically the importance of having defensive exposures.

The selloff from October 3rd to December 24th dragged the S&P 500 Index down by 20% and the Russell small-cap index more than 24%. This was driven primarily by fears of continued rate hikes by the Federal Reserve, valuation concerns, and worries about a global growth slowdown.

These large draw-downs are a far cry from the relatively quiet markets seen in recent years, which drove investors to seek exposures to pro-cyclical market areas such as momentum stocks or high yield credit. As investors adjust to a lower growth paradigm, investors may want to consider exposures that either offer limited downside protection such as minimum volatility strategies or that move less in sync with equity and bonds such as in commodities.

Indeed, investors are taking notice of the importance of defensive positioning. Even with the rebound in stocks this year, our research shows that flows into defensive exchange-traded products are outpacing flows into all products as a percentage of assets under management (see figure below). US-listed fixed income ETFs have garnered nearly twice as much as equity flows year-to-date. Minimum volatility strategies are attracting the biggest flows this year among factors, gaining $5.78 billion, while momentum has seen nearly $0.6 billion in outflows.

Source: BlackRock.

Building a buffer

Here are a few ways investors can add targeted defensives exposures to their portfolios.

1. Equities

Minimum volatility strategies historically have reduced risk in down markets compared to the broader market and Q4 2018 was no exception. The MSCI USA Minimum Volatility Index outperformed the S&P 500 Index by more than 600 basis points in the fourth quarter of 2018. Min vol also worked well in other regions: The MSCI Emerging Markets Minimum Volatility Index outperformed the MSCI Emerging Markets Index by more than 900 bps in 2018.

It is worth noting that minimum volatility strategies historically have tended to perform well both in growth slowdowns and in outright recessionary market conditions. Investors may also want to consider high-quality dividend-paying stocks, which can offer potential income as well as some resilience in down markets as well as adding so-called “safe haven” countries such as Switzerland and Japan.

2. Fixed income

The Federal Reserve has raised interest rates nine times since the tightening cycle began in 2015. Investors who were looking to take advantage of those hikes added exposures to short-term fixed income assets. However, with the market expecting just one more rate hike in 2019, investors concerned with slowing growth or geopolitical turmoil may want to consider longer duration Treasurys (ten years or longer). Historically, these have offered some buffer for portfolios in serious market downturns, as well as a chance to potentially pick up some extra yield.

3. Commodities

Historically, commodities have tended to provide meaningful diversification and inflation hedging benefits.

For example, from April 1991 to March 2019, the annual returns of the S&P GSCI Index have had just a -0.13 correlation to the US Treasury 10 year benchmark index and a 0.25 correlation to the S&P 500 Index.

Source: BlackRock.

In addition, many commodity assets, such as gold, are priced in dollars, and historically have performed in line with an increase in inflation expectations. Therefore, they may serve as an inflation hedge in a portfolio. In the current environment, however, we don’t expect a major increase in inflation.

Some may question where cash fits into a defensive portfolio: While investors generally hold relatively high levels of cash, as the BlackRock Investor Pulse survey has shown, this buffer is increasingly being reallocated to other high quality fixed income options such as US Treasuries as a way to earn an incrementally higher yield.

Let’s be clear: Seeing your portfolio decline in value is never fun, and losing less money than the market at large offers little solace. But over the long term, creating a buffer from the downswings – known as “downside protection” can add value to a portfolio.

There’s an old saying, “You should fix your roof when the sun shines.” We don’t expect a recession in 2019, we still believe stocks will continue to climb and we prefer them over bonds. But the kind of volatility we saw in the fourth quarter could reappear, the result of any number of unforeseen events. When or if that occurs, it would be wise to ready.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)