If Greece is a Black Swan, it's a slow one. Black Swans, you may recall, are Nassim Taleb's famous metaphor for extreme, unforeseeable events that can have nasty implications for financial portfolios and much else. Whatever the fallout from a Greek default, however, the event itself won't be a bolt from the blue. So if you're looking to protect your portfolio, there's time to prepare.
But how, exactly? Professional investors have several suggestions, some of them more feasible than others for retail investors working with publicly available mutual funds and ETFs:
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Sit tight. The simplest response is to do nothing. Active investors might find inaction hard to swallow, but action is often a more costly choice. For one thing, lots of the worry about Greece is already priced into the market, and those who sell now could make the classic mistake of doing the exact wrong thing at the exact wrong time.
"I think a lot of investors are likely better off letting things unfold by being aware of the effect that [the situation] has on their portfolio," says Jeff Tjornehoj, head of Americas research for Lipper, the financial-data provider. Investors should monitor the situation, he says, "but not be panicked by it. The worst time to make a change is at the bottom of a market."
The best protection against extreme events remains "good old asset allocation," says Vassilis Dagiouglu, head of asset allocation for Mellon Capital Management. "Prices already reflect a lot of the bad news," he says. "There may be more downside, but as long as you maintain your equity and your fixed-income [allocations], generally, that will help you navigate through these markets."
Fixed income. If you do decide to act, the most obvious—and perhaps easiest—approach is to minimize equities and maximize fixed-income assets. Lots of folks are moving in that direction. According to IndexUniverse, a website that focuses on ETFs and index funds, fixed-income vehicles in May comprised seven of the top 10 ETFs in terms of net inflows. (The S&P 500 fell 6.3 percent that month, largely on concerns about what will happen in Europe.)
At the top of the list was the Vanguard Total Bond Market ETF Fund (BND), raking in $1.23 billion and putting its assets at just over $17 billion—the third-largest bond ETF by assets under management. Close behind was the iShares Barclays 1-3 Year Treasury Bond Fund (SHY), which took in a net $1.15 billion. Those two funds alone accounted for about a third of May's $7.46 billion in total flows into U.S. bond ETFs.
PIMCO's Total Return ETF (BOND), which launched only in March, has gathered $1.3 billion—a record haul by an actively managed ETF. Although it was designed to track PIMCO's $260 billion Total Return mutual fund (PTTRX), it has outperformed the larger fund by a factor of four (4.97 percent vs. 1.26 percent). One reason: The ETF is much smaller, so it represents what Morningstar ETF analyst Paul Justice calls a "high-conviction pick list" of about 400 positions, compared with the mutual fund's 18,400.
Of course, bonds carry risk, too. If nothing else, there is a significant long-term opportunity cost to being out of equities. There's also interest-rate risk—the danger that rates will rise, as they inevitably will from current historical lows. Rising rates generally hurt the prices of outstanding bonds. Lastly, there's inflation risk: If the economy improves and prices start rising, the real return on bonds will fall.
Some might argue that people nearing retirement should be concerned enough about Europe to substantially boost their fixed-income holdings. But if you're, say, 50 years old, fixed-income assets should already represent maybe half of your holdings. "Trying to time changes in asset allocation is quite challenging," says Mr. Dagiouglu. "I would advise maintaining the current allocation … and not really trying to time when they should be buying or selling bonds."
And you might want to think twice about treasuries, which many analysts say are overpriced. "If you're going to have fixed-income exposure, take credit risk," says Thomas Digenan, U.S. equity strategist at UBS Global Asset Management. "Take well-thought-out credit risk in strong, stable companies."
Dump Europe. Another relatively simple approach is simply to get out of European assets. "If you've got specific European exposure, maybe it's time to walk away if you can't tolerate the volatility anymore," says Morningstar's Justice.
If you're feeling lucky, you could try shorting a European ETF like CurrencyShares Euro Trust (FXE). "You could set it up in your account in about five minutes," says Matt Hougan, president of ETF analytics for IndexUniverse. As with any short, though, timing is everything and the risks are large. If Europe reaches some political resolution to the crisis, bank stocks could soar. "Better for most retail investors to reduce their exposure somewhat if they're really concerned about it," says Hougan.
Preferred shares. Some analysts suggest preferred shares as a way of reducing risk while getting a healthy return. Preferred shares entitle the holder to dividend payments—typically of a fixed amount—ahead of common-share holders, and they rank higher in the claims hierarchy if the company goes bust. You can buy preferred shares through a mutual fund like Nuveen Preferred Securities (NPSAX), which was up 9.93 percent for the year as of June 7.
"As securities, they tend to be most attractive when interest rates are stable or declining," says Lipper's Mr. Tjornehoj. "If the situation in Europe spirals out of control, that would likely send interests rates falling, at least domestically, and that would be a boon to preferred shares."
There's a downside, though. Morningstar's Justice says such funds tend to be heavy on financials, which could be the sector that gets hit hardest by a Greek default. "It's higher in the capital structure," he says, "but the performance just gives you fixed income-like returns and equity-like volatility."
Go for gold. Then, of course, there is that age-old haven, gold. Two of the most popular ETFs right now are the SPDR Gold Trust (GLD) and the iShares Gold Trust (IAU). The latter may be a better option for most people, simply because it has a lower fee—25 basis points vs. 40 for GLD. "There's not a lot of difference in what the performance is going to be," says Justice. "You might as well opt for the cheaper one."
But there's no guarantee that gold will provide the protection many expect. Gold prices fell about 25 percent during the worst of the 2008 crisis, although they quickly recovered. "If there's a panic, people may reach for cash by selling gold," says Hougan, "but it's not entirely clear which direction it will go. As short-term hedge, I don't think you can count on it moving one way or another."
So far this year, notes Lipper's Tjornehoj, Europe's woes have tended to depress gold prices.
"In the long term, gold does not earn its cost of carry," notes UBS's Digenan. "The last time people were this fearful was 1980, and it didn't work out real well for those people." It took three decades for gold prices to recover their inflation-adjusted 1980 peak.
Some argue that you don't even need gold, and caution not to load up on it. There's another, little-known drawback: The IRS treats gold as a "collectible," not a financial investment, and levies a 28 percent tax on any gains, no matter how long you hold it. That compares with a capital-gains tax of 20 percent for financial investments of less than a year, or 15 percent on longer-term gains.
Short the euro. If you prefer to be a little more exotic, you can short the euro. The PowerShares DB U.S. Dollar Index ETF (UUP) takes a long bet on the dollar and a short bet on euro, yen, franc, and several other currencies. Hougan calls it "an easy way for investors to make a bet that the dollar will appreciate against a basket of global currencies highlighted by the euro, without taking on a short account, which involves opening a margin account."
There's no groundswell for this approach, though: UUP posted a net outflow of $61 million in May.
Hell, short everything. Lastly, you can buy put options on some broad index that you think will fall sharply if Greece defaults. A put option entitles the holder to sell something at a given price, and if that price is higher than the market, there's money to be made. If you're convinced a crash is on the way, and you can qualify to trade options (ask your broker), you could buy a long-term put on the S&P 500 through the Chicago Board Options Exchange.
For most investors, though, trading options is riskier than Greece itself. "The problem is that there's a lot of implied leverage in options," says Justice. "People can really burn themselves if they don't know what they're doing."
Hougan agrees. Options "are not for the faint of heart," he says. "If you know how to use them appropriately, you shouldn't be reading an article quoting me about how to prepare yourself."