Protect and grow: how to beat a bear market

And some of the utilities also offer a reasonable yield too. Scottish & Southern Energy goes one better, and is one of the few utilities actively expanding its business. After spending £49m buying Slough Heat & Power, it has recently splashed out on buying Airtricity, an independent wind farm developer. The deal brings with it some €376m of debt but Airtricity has an exciting portfolio of onshore wind farms in Ireland and Scotland that will take Scottish & Southern's renewable energy output up to 1,900MW, making it the largest windfarm operator in Ireland and the UK.

Northumbrian Water is another attractive utility, and its recent performance has been boosted by increases in water and sewerage tariffs allowed by the industry regulator Ofwat. Northumbrian is also keeping a lid on costs mainly as a result of efficiency gains, although the company has warned that these will be offset to some extent by rising energy input costs. However, while the company has raised enough funds to cover the cost of its capital spending programme, it has not raised its tariffs as much as it is allowed to in the three years up to 2010. The management has pledged not to increase its charges up to the maximum allowed but doing so remains a useful option.

There are less well recognised defensive stocks outside the utilities sector as well, but their defensive characteristics differ. One company that has been tipped by several leading analysts is Royal Bank of Scotland (RBS). True, the bank has had to write off £950m as a result of the deterioration in credit markets, but this is a drop in the ocean compared with the billions that US banks have been forced to write off. It's also small beer when compared with the £9.8bn in pre-tax profits that the bank is expected to report. The shares peaked in March last year, since when they have been knocked down by 45 per cent. In fact, the yield on RBS shares at around 7 per cent is better than the bank's standard deposit rates, and the shares are trading on an undemanding PE ratio of 6. RBS has also yet to see the benefits of its recent deal to buy parts of ABN Amro, and while conditions in the financial market are likely to remain grim, RBS still looks cheap.

Vodafone is another relatively defensive stock, and it was quite some time ago that, having saturated the mobile phone market in the UK, the company was accused of being little more than a utility. If that means solid earnings in troubled times, then shareholders are unlikely to complain. And Vodafone has been busy expanding into countries where there is still a relatively low level of mobile phone ownership. The company has estimated that there are over 1bn people without mobile phones in the developing countries where it operates. In India alone, it estimates that over 40 per cent of the population will have a mobile phone by 2012 against 19 per cent now. And through its subsidiary Vodafone Essar it hopes to increase its market share from 18 per cent to 25 per cent.

Land Securities has also been spotted on the radar of some analysts looking for a safe haven, although in this case it is more the case of a bombed-out haven. The company's shares collapsed by 33 per cent last year mainly as a result of worries over the commercial property market. And the current year is also likely to provide a challenge, although analysts appear to be pretty upbeat because of the growing prospect of more than one cut in UK interest rates this year. So the shares look to have been harshly treated, and now trade at a 35 per cent discount to net asset value, which means they are cheap.

Other ways to protect

No one knows whether this is going to be a temporary period of rocky markets or the start of a prolonged bear market but you can take action to make sure that you are protected against a worst-case scenario. Indeed, many investors welcome an increase in volatility, as it creates more opportunities to profit from speculative strategies.

The post-millennial bear market has helped investors by reminding them of risk-reduction strategies. It also encouraged product innovation, creating a much wider range of tools that can be used to limit downside or profit in a falling market.

The simplest way to reduce the volatility of your portfolio is to diversify your exposure across a variety of asset classes, rather than restricting yourself to shares. You can also invest in actively-managed funds which aim to deliver absolute returns, regardless of market conditions.

Another alternative is to use structured products, which allow you to take market exposure without risking your initial capital. Finally, more sophisticated investors could employ derivatives, either to hedge their portfolios or to speculate on the prospect of falling share prices.

Outlook

The decade began badly for investors, with global markets losing around half their values between 2000 and 2002 but markets rebounded from 2003 onwards, producing a 90 per cent return from the FTSE All-Share index over the past five years. However, the bull run broke down in 2007 and the FTSE All-Share has fallen by 11 per cent in the past six months.

Sentiment deteriorated in 2007 due to the credit crunch, which made both banks and investors reassess their attitudes to risk. Banks want to protect themselves against bad debts and have tightened their lending criteria, which could hinder economic growth, not to mention curtailing the takeover boom which had been boosting stock markets.

Investors have become nervous, unsure how bad things could get, leading to panic selling on bad newsflow. For instance, shares in Marks & Spencer fell by 19 per cent in a single day after the retailer announced that its third quarter sales were down by 2 per cent year-on-year.

There are concerns that consumer spending could fall sharply, especially if the residential property market slumps. There are also fears of inflation hitting profits and economic growth, especially with the price of oil breaking the $100-a-barrel level for the first time ever in 2008.

Many professional investors are optimistic, despite the gloomy newsflow. For instance, Bob Doll, chief investment officer at fund manager BlackRock, thinks interest rate cuts by central banks will help the world avoid an economic recession this year and says that, while markets will remain volatile, the bull market should continue, leading to "a new high at some point during the year".

However, others are more bearish, fearing a market crash. Ian Rushbrook, manager of investment trust Personal Assets, warned last May that the FTSE All Share was 45 per cent overvalued. He moved half his fund into cash and used derivatives to protect the remainder of the portfolio against the risk that the "bubble" could burst.

Diversification

As we mentioned earlier, switching into cash could mean you miss out on share price rallies. There is also an argument against trading frequently, as costs hurt your returns. A buy and hold strategy could be combined with regular savings or using phased investment facilities (where lump sums are invested through fund supermarkets over several months) so pound-cost averaging should smooth out the effects of market volatility, as you buy would buy more units when prices are cheap.

You can also build up a very low-cost portfolio using index tracker funds, especially exchange-traded funds (ETFs), which can be traded without stamp duty and have very low management charges. Broker Selftrade allows you to buy ETFs cost-free in its self-select individual savings account (Isa) wrapper. See www.londonstockexchange.com for more on ETFs.

Nevertheless, even if you do not want to risk trading on market momentum, you should still buy and hold with a view to diversifying against the risk of stock market downside through asset allocation. In a nutshell, don’t put all your eggs in one basket; investing across a range of asset classes with low correlations means that falls in one part of your portfolio should be offset by gains in another.

As the table below shows, investing in shares alone gives you little diversification, even if you invest internationally. For example, the US S&P 500 index has a 71 per cent correlation with the FTSE100 over five years.

By contrast, investing in gilts (UK government bonds) should provide diversification, with a five-year correlation of -23 per cent. Gilts tend to prosper when shares do badly because their prices rise when interest rates are cut and they also benefit from a flight to safety by risk-averse investors.

Asset correlation

Investors heading towards retirement are likely to be seeking income and capital protection, rather than growth, so independent financial advisers (IFAs) use the rule of thumb that you should have the same percentage of low-risk assets (such as gilts, cash and, arguably, property) in your portfolio as your age. Bearish IFA David Kauders thinks gilts are the only asset worth holding at the moment - see www.contraryview.co.uk.

One potential fly in the ointment if you want to diversify is that correlations between different asset classes have increased recently, along with volatility, so there is a risk that several asset classes could fall together. Indeed, the commercial property market has already slumped, affected by the same concerns that have weakened stock markets.

Unfortunately, historical trends can change. For example, commodities have been good diversifiers in the past but are now showing a strong correlation with shares.

That said, gold should act as a safe haven in a crash. Even though it is trading near its all time price high, there is much further to go, in inflation-adjusted terms. Corporate bonds can provide gilt-like diversification but could default in a recession, leading to a positive correlation with shares over the past six months, as concerns about credit quality have grown.

It is now easy to build up diversified fund portfolios on fund supermarket platforms - you can do your own research online and buy through discount-broking IFAs to minimise charges. For a useful, interactive guide to asset allocation, visit the investment planning section at www.bestinvest.co.uk.

Absolute return funds

Rather than building a up a portfolio of uncorrelated funds, you could invest in a multi-asset fund. These are funds-of-funds where an overall manager manages the portfolio for you, rebalancing it to suit market conditions or to replace underlying funds (without triggering capital gains tax liabilities).

The main drawbacks of using multi-asset funds are that the charges are higher - typically around 2.5 per cent, compared with 1.5 per cent for a single fund - and that you might have to sell your entire fund, if the manager leaves.

With-profits funds also hold diversified portfolios, including shares, bonds and property. You can buy into with-profits funds at a discount (with a guaranteed sum-assured) by buying traded endowment policies.

An alternative way to aim for absolute returns – that is, positive returns each year, aiming to beat cash, rather than than returns relative to an equity index – is to use hedge funds. Hedge funds use a variety of strategies and aim to make money in all market conditions.

Many hedge funds aim to make money by going short using derivatives (aiming to profit from falling prices), rather than just long-only investing (which depends on rising prices). Hedge funds should be low-risk investments but things can go spectacularly wrong so the best approach is to use a fund-of-hedge-funds. The simplest way to invest is through one of the funds of hedge funds listed as an investment trust. These can be held inside Isas and traded instantly, avoiding the high minimum investments and lengthy redemption periods that come with offshore hedge funds.

The absolute return approach is also taking hold in the world of conventional funds. Some investment trust managers have been using derivatives to protect their portfolios for years and the trend has now spread to open-ended funds

A number of open-ended fund managers have started aiming for absolute returns, with a mixture of long and short positions. These are sometimes referred to as 130/30 funds (due to the balance of long and short holdings) and there are also target return bond funds, which use derivatives to try to profit from moves in interest rates.

Structured products

Structured products are effectively passively managed absolute return funds, which provide the possibility of market upside with full or partial capital protection. They are made up of derivatives for market exposure and gilts or cash for capital preservation.

Just as absolute return funds would underperform long-only funds in a bull market, you give up something for the capital preservation offered by structured products: there is no dividend yield. This could be a problem in a flat market, although some structured products could compensate for this by enhancing gains in a rising market (offering 130 per cent upside exposure, for example).

Retail structured products must be held for a fixed-term to guarantee the return of your initial capital but synthetics (structured investment trusts) can be traded at any time, allowing you to take profits. A synthetic’s initial share price is normally guaranteed at maturity.

There are also structured products which offer high incomes but there could be significant capital losses, if stock markets fall below predetermined levels. This happened in the last bear market, leading them to be known as ‘precipice bonds’.

For more on current structured product offers, ask your broker or IFA. Brokers can be found through www.apcims.co.uk and IFAs can be found through www.unbiased.co.uk.

Derivatives

Derivatives are financial instruments related to the prices of individual shares, assets or indices, which allow investors to go short, profiting from a falling price.

Derivatives enhance any gains or losses in the underlying prices they track so they are often perceived as being risky investments, but they do not have to be. They can be used to reduce your risk by hedging your long exposure - buying insurance for your portfolio - or to speculate on falling prices, increasing risk.

The safest derivatives for hedging are options and covered warrants, as the most you could lose is the premium paid, if the market moves against you. To go short, buy a ‘put’ (whereas calls allow you to go long).

Options and warrant pricing is not straightforward. You need to consider the length of time to expiry and whether the underlying price is at the strike price. To hedge yourself against the possibility of a severe market crash in the medium term, buy an out-of-the-money put, with a while left to expiry. To profit from an antipated short-term fall, buy a put which is at- or in-the-money, with little time to expiry.

Another possibility with options (but not covered warrants) is writing options. If you think the market will stay flat or fall, you could sell calls, hoping that they will expire worthless, leaving you with your assets and the premiums received. If the market rose, you would have to sell your holdings at the strike price but this would allow you to take profits (in a market you considered expensive).

Spread betting (which is tax-free), futures and contracts for difference (CFDs) are simpler to understand in pricing terms. Futures normally expose you to 1,000 shares, while you can choose your exposure levels with spread betting and CFDs (£1 per 1p move in the underlying price, say).

On the other hand, you need to deposit a margin and you could make substantial losses, if the market moves against you. You can protect yourself by setting stop-losses with your broker – these are trading orders which would close your position at a predetermined level.