The Simplest Way to Safeguard Your Investments Before a Market Selloff

With all the talk of a possible bear market lurking just around the bend, it's no wonder that investors are terrified of stocks. In the past 12 months they've yanked $110 billion from U.S. equity portfolios.

So if you're a mutual fund company, what do you do? You promote funds that promise a big cut of the current bull market's gains while claiming to have a secret sauce for protecting investors when a selloff strikes.

Enter alternative funds, or "alts," which use strategies pioneered by hedge funds that will, theoretically, lessen a bear's bite. "Long/short" equity funds try to do that by betting on parts of the market while simultaneously betting against, or short-selling, other shares or sectors. "Market neutral" funds are similar, but they make equal-size bets on and against equities, neutralizing the impact of overall market swings. Gains come instead from the fund manager's ability to pick the right stocks to invest in or to short.

Is this bear protection worth it? Probably not, and here's why:

The Track Record

Relatively few alt funds have even a five-year record, and that makes it tough to evaluate their efficacy—especially in a bear. Schwab Hedged Equity is one of the few such funds with a long record, having beaten most of its peers over the past one, three, and five years. In the 2008 crash, it lost 17 percentage points less than the S&P 500. But the following year the fund trailed the market by 11 points, and over the past five years it has lagged by eight points annually.

One reason alts struggle over time is expenses. The average long/short fund charges 1.87%. The Schwab fund charges 1.33%, but that's still one point more than the fees on many stock index funds.

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The Simpler Alternative

If dampening potential bear-market losses is your aim, adding exposure to bond funds or cash may be just as effective as hedging. And you may not even need to add that much more ballast if you're a diversified investor. A Vanguard study found that a simple 60% stock/40% bond portfolio can provide much of the same type of protection you're seeking from a hedge-fund-like strategy.

A 60/40 strategy held its own against many types of hedge funds in the 2007–09 bear, and it trounced long/short- and market-neutral-style hedge funds by more than 10 percentage points from March 2009 through the end of 2011.

Just remember: If you are living in terror of a bear market now but are investing for the next 20 years or longer, the last thing you want to do is hedge your portfolio in such a way that it leaves you poorer in the long run.

John Waggoner has written three books on Wall Street and investing.

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