Axel Merk explores several methods of portfolio protection.

While the new year’s market mayhem has refocused investor attention on downside protection, Axel Merk warns that standard risk-reduction strategies are not without their own risks.

Nevertheless, the Merk Investments gold and currencies portfolio manager lays out the options for investors seeking to crash-proof their portfolios in 2015 in his latest commentary published Wednesday.

The volatility that has slashed stock prices (and lifted bonds) in the first few trading days of the new year confronts investors with the challenge of determining whether the market shift is a buying opportunity or signal of worse to come.

But the fund manager is seizing the moment to remind investors of a fundamental investment principle that is meant to avert such painful decisions: diversification.

Properly achieved, diversification may be the one path permitting investors to have their cake and eat it too — by participating in a bull market while gaining protection against extreme events.

In his commentary, Merk first explores alternative forms of portfolio protection of which he is unenthusiastic, cautious or sharply critical.

One approach is insurance via structured products, but that involves counterparty risk — the possibility that the issuer cannot back up its liabilities.

One can mitigate counterparty risk through put options, since the options are cleared through exchanges. But Merk is still skeptical because of the cost of such protection.

“Just like flood insurance, the worst time to buy insurance is when one is in the middle of a flood,” he writes.

But even were one to buy during a drought, he warns that costs will tend to rise amid period renewals based on three factors: as investors extend the duration of their protection; as they seek increased protection against loss (i.e., limit the amount they are willing to lose); and as market volatility increases.

The upshot is that put options can cost investors 4% to 5% annually to protect against a 15 to 20% market decline — and that’s in a low-volatility environment.

What’s more, investors pay that cost whether the market is up 20% (in which case their options expire worthless) or up just 5% (in which case an investor loses “both on the S&P, as well as on the cost of the insurance”). He adds: “Did I mention that the cost of buying protection might move up considerably during more volatile periods?”

Merk moves on in his desultory discussion of portfolio insurance with the strategy of writing covered call options as a means of generating income in a sideways market — a strategy best left to one who “either understands them well or has the guidance of an expert.”

He prefers a “currency overlay” as a means of generating portfolio income but warns this is suitable for family offices of institutional investors, not individual investors.

Thus dismissing insurance as too costly or complex to be practical for most investors, Merk returns to portfolio diversification but raises the question of just what constitutes “‘less risky’ these days.”

The first alternative is cash. But, writes the fund manager: “In an era of negative real interest rates, cash is certain to rob investors of their purchasing power. As such, we don’t call cash risk free anymore. Howefver, cash is indeed at the lower end of the risk spectrum.”

A second alternative is bonds, which historically have been used to counterbalance equities. Still, noting that bonds have performed quite well recently, Merk states without further explanation that “many not-so-risky assets might be masking risks,” suggesting that investors might have grounds to fear a crash in the bond market as well.

Finally come “uncorrelated strategies,” though he warns that “in an ‘extreme’ market, many strategies may not be that uncorrelated after all; neither will their volatility be necessarily low.”

These include MLPs investing in oil and gas, though they have taken quite a beating recently as energy prices crater; long/short strategies, though Merk worries an extreme crisis might forestall the possibility of shorting.

The gold and currencies manager suggests that long/short currency strategies may not face such liquidity constraints and notes that gold has historically exhibited “low correlation to other markets.”

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