Last month I asked in these pages, Is This An Epic Bear Market Breach Or Flash In The Pan? My answer to the question is that no one really knows what millions of investors will do tomorrow or the next day, week or month, but the warning signs of impending volatility and disorder were indeed troubling. Our response was to begin liquidating a substantial portion of our long portfolios and adding a like percentage of downside hedges. Those actions are now complete. We are roughly market neutral. But that doesn’t mean we are willing to step away from the rewards the market itself can provide, even in a market neutral portfolio. 

Over the last couple of decades, more than 70% of the total market return has come from dividend income. Much of this “dividend income” is really interest from fixed income investments that is packaged by ETFs and closed-end funds and received as dividends. Some of it, as well, comes from preferred shares, where the income amount paid is fixed but, again, is considered dividend income. 

So while we wait on the sidelines, fearing neither market ruin nor lamenting any loss of possible gain, we have created “The UN-Beta Portfolio” for our clients and ourselves. Our “happy to stand by while things shake out in the next few months” holdings now look like this…

Up to 50% in fixed income. This includes sovereign bonds of developed nations that are now embarking on their own QE, keeping their bond yields low and creating a floor under their prices;  investment grade US municipal bonds; and US multi-sector bonds that have little or no correlation to US stocks and look like great holds if the Fed is constrained this year in raising rates. Of course, there are many venues to invest in fixed income assets. Our choices are typically bond mutual funds, bond closed-end funds, and bond ETFs.

30% plus or minus long positions.Long, yes -- but here is where The UN-Beta Portfolio differs from the typical long-side portfolio, whether that other portfolio holds the FANGs, blue chips, or dividend aristocrats. No matter how wonderful the dividends of common stocks, it is all moot if the price of the stock plunges. Yes, you received 4.1% in a rock solid dividend. Too bad the company’s shares plunged 25%. Our longs in this portfolio are long/short funds, which tend to have a modest long bias but offer great downside protection;  preferred shares, which can fluctuate considerably in price but almost never as much as the issuing company’s common stock; utilities that offer good yield and good valuation metrics; and REITs that are typically underwhelming in frothy bull markets and thus cheap today.

10% cash / long special situations or favored sectors. If we don’t find sectors we like in the bad times, we stay in cash. There will always be some special situation that comes along worthy of our consideration, but they may stay in the portfolio for only a very short period of time.

No more than 10% in various short positions, primarily against US small and mid caps and, especially, emerging markets. The latter have been on fire lately as Brazil and Argentina are talking nice to creditors and China is pulling out all the stops to keep its house of cards from tumbling down. We have taken this opportunity to add to positions.

Manning the Battlements

Here are some examples of specific holdings in each of the areas we have decided to invest in:

One example of a mutual fund we are buying to take advantage of the floor under sovereign nation debt created by declining rates dictated by their central bankers is the PIMCO Foreign Bond (US Dollar-Hedged) Fund (PFOAX / PFODX.) If you use Morningstar, you might think this fund has serious style drift since 63% of its holdings are listed as being in the USA. Upon closer inspection, however, you will see that, while PFOAX’s charter allows them much flexibility based upon their experienced market analysis, they aren’t really that heavy in the US. What they actually hold are interest rate swaps issued in the US that allow them to hedge their foreign bond positions.In fact, most of their holdings are in developed nation foreign government bonds. Since inception, this fund has blown the doors off the international bond category and currently pays a 6.5% yield.

Among the myriad closed-end and ETF municipal offerings, one of the ETFs we are buying, particularly for those clients who need AMT-free income, is PowerShares National AMT-Free Muni Bond (PZA). While it only pays a 3.6% yield, if you are in a high bracket and subject to the IRS’s Alternative Minimum Tax, the after-tax yield equivalent is considerably better!In the closed-end space, one of our favorites is the BlackRock Investment Quality Municipals Fund (BKN). Yielding 5.6%, all from income, none from return of capital, more than 80% of its holdings are in the top 3 rating categories. 

While we’re at it, let’s discuss an old shibboleth about municipals. For years, advisors of many stripes have told investors there is no value in buying municipals unless you are in a high tax bracket and there is “certainly” no value in buying them in an IRA.It’s true that you derive no tax advantage to buying munis in an IRA. But many of our clients and readers have only IRA accounts. Would I deprive them of a high-quality, low-volatility 5.6% yield in troubled times? Of course not!If you have both a non-tax-advantaged account and an IRA, I’d suggest you buy in the former – the after-tax equivalent, for example, for a married couple making $100,000 a year and paying a 6% state income tax in the state of issue of the municipal on top of their 25% federal rate would be 8%, not 5.6%.But many retired investors are in lower brackets and wouldn’t see that much difference.Always do your due diligence and let the “experts” worry about their illusions.

For a US bond fund that looks a lot better now that it is less likely the Fed will go wild on rate increases this year would be PIMCO Income Class A and Class D — PONAX and PONDX. PONAX is a “multi-sector” fund, which means it can buy sovereign bonds, corporate bonds, agency bonds, or any other kind of debt security and they can do it anywhere in the world. They have chosen, however, to specialize in US non-agency mortgage debt.Good timing. As US lenders have tightened up the qualifications for home buyers, the quality of holdings available for purchase today is higher than it was in the recent past. But since many possible bond buyers are still wary, the yields are particularly good — this goes for residential as well as commercial mortgages.

The steadiness of its mortgage, sovereign, US and foreign bond payments allows PONAX to pay a monthly dividend. In order never to pay out too much the current monthly payout is augmented at year-end by an extra dividend. PONAX/PONDX has done this successfully for years without ever once paying any return of capital; what they pay out is what they have earned, nothing more.

I have a number of other favorites in this area but, for now, I’ll just discuss one other PIMCO fund. While PIMCO lost investor assets when guru Bill Gross left in a huff, their performance certainly hasn’t suffered one bit. It seems the impact of Mr. Gross leaving was every bit as large as the hole left behind when one sticks their finger in a glass of water and then removes it. 

This one is PIMCO’s Mortgage Opportunities, with my preferred asset classes being the A and D shares (PMZAX / PMZDX). As the name implies, PMZAX operates in the commercial and residential mortgage-backed and asset-backed securities arena. Given investor fears (I believe unwarranted) of a repeat of a 2007-2008 housing bubble, these bonds trade at a discount to other equally-rated bonds. PMZAX invests primarily in the US and European markets and has the right by charter to hedge / short in order to mitigate risks. PMZAX is a relatively new fund, but one I think is on the right track to protect us in difficult markets.

Finally (for this article anyway) I’ll discuss just a couple of the many preferred shares we own in our UN-Beta Portfolio. Preferred tend to pay slightly better than bonds (and preferred shareholders are lower in the hierarchy of creditors who get paid off in the event of a corporate bankruptcy.)They are issued by corporations and may have a fixed date or be issued in perpetuity. With preferred, you need to be reasonably certain that the underlying company has a clean balance sheet and a good future. I like banks, insurers and REITs the best for our preferred portfolio.Some of my favorites are every single one of those issued by Public Storage (PSA). Some symbols are PSA-A, T, U, and V.  And my most recent purchase has been the “J” preferred from NextEra Energy (NEE). NextEra is the parent company of, among many other subsidiaries, Florida Power and Light which, thanks to NEE’s leadership, just reduced its rates, unheard of these days. And, finally, if you don't want the bother of watching these and don’t like their relative illiquidity — people buy them to hold, so the trading volume tends to be small — take a look at ETFs PGF and PGX. (Our clients mostly own the preferred themselves, not the ETFs.)

I’ll discuss other fine holdings in The UN-Beta Portfolio in future articles. Starting here, you’ll likely sleep better if the market declines and only miss some of the gains if it roars ahead. Personally, I don’t mind a bit stepping aside from the long side of the market and have done so many times in the past.When the bear cycle is upon us, Wall Street can yammer on all they like about “defensive” holdings, but by now I’m sure you realize that’s what we financial professionals call, in technical terms, “a bunch of hooey.” Wall Street will tell you that food and beverage firms are defensive because “people gotta eat” or that housing stocks are defensive because “everyone has to have a place to live.” Maybe so. But no one has to pay 20 times earnings for the privilege of owning these stocks. And in most bear cycles, if the stocks’ PEs decline from 20 to 10, that takes your stock from a price of 30 to 15 or 80 to 40, etc. That, to me, is not defensive! It is merely bleeding slowly rather than watch your life’s blood exit all at once.We don’t believe in hemorrhaging when the market is down. Eating well and sleeping well is the best revenge.

>>> Read: Protection Always Beats Prediction (The Un-Beta Portfolio Part II)