A portfolio that shines when crisis hits

Cash is king in uncertain times for financial markets, but what a royal pain it is for investors.

In return for bullet-proof safety, you get returns below the 1-per-cent mark. What if you could crank up your returns substantially in up and down markets while still keeping risk contained?

This is exactly the result achieved by the Defensive ETF Portfolio designed by analysts at National Bank Financial. This grouping of eight exchange-traded funds was up 4.8 per cent for the year through Sept. 30 on a total return basis (bond interest and dividends plus ETF price changes), while the S&P/TSX 60 index of big blue chips was down 11.6 per cent.

The last time the stock market crashed, the portfolio was even more dramatically effective. For the 12 months starting Sept. 1, 2008, it gained 8.5 per cent while the 60 index fell 18 per cent.

"The Defensive ETF Portfolio is for times when crisis hits," said analyst Pat Chiefalo of National Bank Financial. "You would look to something like this at times when we have something mirroring the 2008-09 time frame."

A few months ago, Mr. Chiefalo and his colleagues were looking at the markets and wondering if something along those lines was happening again. That set them to work looking for ETFs that outperformed on a relative basis during the financial crisis, which essentially means they lost the least money.

It turns out that some ETFs actually made money during the peak of the crisis, which the NBF analysts defined as September, 2008, to September, 2009. These ETFs were gathered together in the defensive portfolio, which showed its stuff again in the most recent stock market decline.

Bonds are the backbone of the defensive portfolio with a weighting of 58 per cent. An ETF that covers the entire bond market is the biggest holding, with smaller amounts going into a corporate bond ETF and a short-term bond ETF. Corporate bonds add a little extra yield with additional risk, while short-term bonds do just the opposite.

The 31-per-cent position in stocks suggests more risk than there actually is because about 12 per cent of the portfolio is in preferred shares. Preferred shares are mainly a vehicle for generating dividend income and they don't jump around in price as much as the common shares that make up most of the stock market.

Small positions in gold and consumer staples stocks are also included in the defensive portfolio, but that's it for stocks. This lack of broad stock market exposure suggests the Defensive ETF Portfolio is not an ideal portfolio for all financial conditions. "It's excessively defensive," Mr. Chiefalo said. In a bull market for stocks, "you'd want to crank up your market exposure."

Rounding out the defensive portfolio is a 6-per-cent position in an ETF that does the same job as a money market fund and a 5-per-cent weighting in a gold bullion ETF.

The Defensive ETF Portfolio is designed more to preserve your portfolio than to grow it. But it also teaches us a lesson about investing in markets with violent ups and downs: Pay more attention to limiting losses when the market is falling than to positioning yourself for gains when the market is rising.

Even while underperforming the stock market badly in 2009 and 2010, the defensive portfolio produced a cumulative total return over the three years to Sept. 30 of 27.9 per cent. The 60 index, by comparison, was down 11.4 per cent over that period. You might say that by minding the downside, the defensive portfolio let the upside take care of itself.

This past September, the portfolio once again stood up well in a falling stock market. Its gain of 0.1 per cent during the month compares to an 8.1-per-cent drop for the 60 index.

Despite its consistent resiliency in down markets, it's important to realize that the Defensive ETF Portfolio is not virtually loss-proof, like cash is. The portfolio's maximum drawdown, or biggest one-time decline, over the past three-year span was 7.7 per cent, which looks good only in comparison to the 60 index's maximum drop of 43.4-per-cent.

With its heavy weighting in bonds, the defensive portfolio is vulnerable to rising interest rates (bonds and bond funds fall in price when rates rise). The 14.3-per-cent weighting in gold will be a drag at times like now, when gold prices are falling.

In fact, gold was the biggest drag on the defensive portfolio in September. The gold bullion ETF in the mix, the Horizons BetaPro COMEX Gold ETF (IGT), fell 4.9 per cent and the ETF that tracks gold stocks, the iShares S&P/TSX Global Gold Index Fund (XGD), fell 5.7 per cent.

Still, gold is widely considered to be a top defensive choice for investors, and it was in fine form during the 12 months starting in September, 2008. The gold bullion component of the defensive portfolio gained 17.9 per cent during that period, while gold stocks rose 8.6 per cent.

One thing you won't find in the defensive portfolio is much foreign content. Global exposure comes in at just 3 per cent of the whole – roughly 2 per cent in the United States and 1 per cent internationally. "It is prudent to reduce exposure to international and emerging markets, which tend to be the most volatile during periods of market upheaval, "Mr. Chiefalo and his colleagues say in a summary of the defensive portfolio's recent performance.

One last advantage for the defensive portfolio over cash is its much fatter stream of income. The yield on the portfolio over the past 12 months was 2.9 per cent and it's generated through a mix of interest income from the three bond ETFs in the mix, and dividends from the preferred share and consumer staples ETFs.

Cash? A one-year Government of Canada Treasury Bill now yields about 0.9 per cent. Some king.

Breaking Down The Defensive ETF Portfolio

Here are the exchange-traded funds that make up the Defensive ETF Portfolio. Each was selected on the basis of having delivered positive returns during the stock market selloff from September 2008 to September 2009.

Defensive Portfolio Returns: The Long View

Defensive Portfolio Returns: The Year-By-Year View

* Price return of monthly rebalanced portfolio; underlying benchmark indexes less MER modelled for periods predating ETF's inception; YTD returns to Sept. 30. Source: Bloomberg, National Bank Financial

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