8 Ways to Protect Mutual Funds From a Financial Crisis

Many investors, like the economy in general, have been in recovery mode since the crash of 2008. As the economy seems to be on the upswing, even those looking to get back into the investing game may do so with considerable trepidation. While there is a certain amount of risk inherent in every type of investment, wary investors are looking for ways to protect their portfolios from the ravages of the next financial crisis, whenever it may occur.

Mutual funds, in particular, offer a number of ways to invest while limiting your exposure to economic turmoil in the United States. From investing in foreign bonds and U.S. government bonds to taking advantage of overseas stock opportunities and ultra-short-term debt products, there are eight key strategies you can employ to mitigate your risk and protect your mutual fund investments from the next crash.

Bonds are traditionally considered one of the safer investment vehicles because they provide returns of principal and guaranteed interest payments each year. When it comes to protecting your mutual fund investment from economic unrest, government-issued bonds are even safer than corporate bonds. Though the markets may crash and the economy may take a dive, the likelihood of the U.S. government declaring bankruptcy and defaulting on its obligations to bondholders is low.

Similarly, investing in bond funds that specialize in debt issued by highly stable foreign governments can help mitigate the risk of an American crash. Though the U.S. economy undoubtedly affects those of other nations, the impact of an American crash is unlikely to make most large first-world countries insolvent. Stay away from bond funds that invest in riskier countries, such as Greece, since they bring a degree of risk that could be avoided by simply "buying local." To protect against the risk of inflation as interest rates rise, you can invest in inflation-protected funds that invest in domestic and foreign bonds with coupon rates that change with inflation.

In addition to foreign bonds, funds that invest in highly rated foreign corporate stocks are also a good way to limit your risk in a volatile market. Again, though an American crisis can, and did, have far-reaching effects, stable, well-governed foreign corporations are unlikely to suffer too badly if the U.S. markets take a dive. In fact, some foreign stocks may actually gain value if the market crashes and its U.S. competitors take a serious hit.

One of the key drivers of the 2008 crisis was the misuse of leverage by the financial industry. While leverage can be an excellent mechanism that allows funds to generate accelerated profits, it also significantly increases a fund's risk. Mutual funds are highly restricted with regard to the amount of leverage they can use. In fact, the maximum amount of money a fund can borrow is 33% of its total portfolio value. Though this is much lower than the leverage used by most hedge funds, for example, it still increases the likelihood of the fund becoming insolvent in the event of a market downturn. If you are looking to eliminate unnecessary risk, steer clear of leverage funds and other debt-fueled products.

Money market funds are widely considered some of the most stable mutual funds around. Because these funds invest only in ultra-short-term debt issued by the U.S. government or very highly rated corporations, the risk of default is incredibly low. Of course, minimal risk typically means limited returns, so money market funds are not built for serious wealth creation. However, they can be a low-risk resource for those looking to hedge against a potential crisis.

Although the stock market is often painted as one of the riskiest places to put your money, protecting your mutual funds from economic turmoil does not have to mean avoiding stocks altogether. There are several stocks, called noncyclical stocks, that tend to remain relatively stable during a bear market because the issuing companies provide goods and services that people need regardless of the economy. The utilities sector is an excellent example of a noncyclical industry because people need to have electricity, gas, and water no matter how the economy is doing. Alcohol and tobacco, though certainly not necessities, also remain strong during a down market because consumers are willing to spend money on these items even when funds are tight.

The aftermath of the 2008 crisis had investors looking for a new way to invest that did not require returns to be so closely correlated to the health of the market. New mutual funds have been developed, named alternative funds, that utilize investing strategies normally reserved for hedge funds, such as arbitrage investing. Although some strategies, such as the use of leverage or illiquid securities, are not built for portfolio protection, these funds do allow investors to mitigate risk by taking long and short positions in stocks and derivative securities. When the market tanks, these funds allow shareholders to benefit from the downturn by betting on the success and failure of different assets.

One of the chief benefits of mutual fund investing is it automatically provides a significant degree of diversification. However, to protect your fund investments from the next financial crisis, diversify further by investing in different types of funds, such as the ones mentioned above, to spread your risk around.

One of the primary reasons investors lost so much during the financial crisis was that, gripped by panic, everyone liquidated their investments at once, creating additional strain on the financial system. Those who rode out the storm and left investments in place generally recovered what was lost over time. If you are inclined toward a more short-term investing strategy, a crisis can actually provide a lot of opportunity for profit but at a considerable risk. However, most mutual funds are designed to be long-term investments, so go ahead and hold on to them for the long haul.

Even if the next financial crisis hits next year, the likelihood the U.S. economy will be forever devastated is low. Every economy has ups and downs, some big and some small, but the overall performance of the U.S. markets over time has been bullish. The most important thing you can do to shield your mutual funds from the ravages of an economic freefall is to take a deep breath and wait for the storm to pass.