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For advisors who manage portfolio risk by overweighting non-cyclical sectors, 2012 has been a painful year as the Utility sector has been surprisingly volatile. The year, however, illustrates why advisors may want to consider cushioning risk by using alternative investments or funds that use a combination of short positions and traditional long positions.

In some instances, those funds may decline less than non-cyclical stocks. By embracing alternative investments, furthermore, advisors can also gain a competitive edge by showing clients and prospects how they can manage portfolio volatility.

Following the sub-prime mortgage crisis of 2009 and subsequent bear market, many investors have become risk intolerant, causing advisors to try to reduce the impact of market downturns by overweighting Utilities and Consumer Staples. The thinking is that those sectors are non-cyclical and therefore less likely to decline as drastically as the broad market when equities retreat.

In addition, Utility holdings typically pay attractive dividends. The dividend income can help cushion the impact of declining stock prices. The stocks also become more attractive when their trading prices decline because the price changes result in the stocks’ dividend yield, as measured as a percentage of invested capital, increasing.

For the first half of 2012, the strong appeal of the non-cyclical sectors—especially Utilities—resulted in valuations climbing substantially. Within the S&P 500 Index, Consumer Staples gained 11.99% and Utilities gained 10.29% in 2012 through July 30.

Both sectors considerably outperformed the 9.79% return of the S&P 500 Index. At that point, however, defensive investing got ugly. Even though the S&P 500 climbed a solid 2.54% from July 30 to November 23, Utilities dropped a significant 9.90%, while Consumer Staples returned an anemic 0.13%.

From a longer term perspective, Consumer Staples were more encouraging, generating a 12.14% return from January 3 of 2012 to November 23, compared to the 12.57% return of the S&P 500. Utilities, however, stayed negative with a decline of 0.63%. The lesson for advisors is that overweighting non-cyclical sectors may not always dampen risk. Sometimes it may actually increase performance volatility.

Alternative investments—or at least some categories of alternative investments—in comparison, avoided losses during the first 11 months of 2012, suggesting that the funds may have been a more appropriate method for offsetting risk.

Alternative investments, of course are a broad category of assets. They can include options, commodities, real estate and other asset classes. Common strategies include market neutral, which entails maintaining an equal allocation to long positions and short positions and long/short funds, which consists of funds that vary their allocation to long and short positions.

Impressively, Morningstar’s Long/Short Equity and Market Neutral categories generated positive returns during periods when Utility and Consumer Staples sectors declined. Initially, the two fund categories underperformed both the broad market and the non-cyclical sectors.

From January 3 to July 30, for example, the Long/Short category returned 2.89% and the Market Neutral category returned 0.62%. Yet, from July 30 to November 23, which is when Utilities declined substantially, the Long/Short Equity category returned 0.65% and the Market Neutral category returned 0.14%. For year-to-date as of November 23, Long/Short category returned 3.87% and Market Neutral category returned 0.14%.

The performance comparison, however, is limited to just one year, but it illustrates how alternative investments have the potential to avoid losses and therefore dampen volatility when other sectors decline and therefore be attractive tools for managing risk. Even if the funds do at times decline more than non-cyclical stocks, their performance may have a low correlation to the S&P 500, which over time can help dampen volatility.

For advisors, using alternative investments may accomplish more than simply dampening portfolio volatility. Indeed, advisors with potential clients who are risk averse can create asset allocation models that illustrate how alternative investments can lower portfolio volatility. By including the funds in an asset allocation, advisors can demonstrate that they are willing—and capable—of evaluating a wide range of investments to dampen portfolio volatility. That may give advisors an edge over competitors that may not take time and or commit to understanding how alternative investments can help cushion against market declines.

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