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With governments and central bankers pulling out the stops to curb risk and keep rates low, investors should focus on areas beyond policy makers’ control to hedge their portfolios. For most, long options positions in currencies provide much cheaper and more effective hedges than more popular equity-index options.

There are various reasons to hedge your portfolio. Maybe you’re fearful that a pending earnings announcement from a sizable long-term holding might cause a pullback in the stock. Maybe you’re worried that the market will have a short-term correction because risk assets have come too far, too fast. But what keeps us up at night is the risk of a major market disruption that could wipe out a large portion of your nest egg.

And if there is anything to be learned from the past four years, it’s that, given the right circumstances, things can go very wrong, very fast.

Also, it’s reasonable to assume that the ability of governments to right the ship is diminished at this point, given all the moves they’ve already made. While Chicken Little was overreacting when he warned that “the sky is falling,” the prudent investor isn’t overreacting when he tries to protect his portfolio from a big tumble on Wall Street, regardless of how remote that danger seems.

Central banks around the world are working overtime to limit the big risks that face the global financial system. As long as political will stays strong, you may have to worry more about the purchasing power of your investments than their dollar value.

Unfortunately, there’s a greater than zero chance that the powers that be can’t control all events. Risks to consider include major slowing in China, military conflict in the Middle East, an inability to generate sustainable growth in the U.S., and the problems in Europe.

While all of these issues are real, Europe deserves the most attention. The countries at the periphery of the euro zone are uncompetitive and saddled with debt. The debt must come down, while labor needs to become cheaper. The current solution involves some monetary easing and a lot of austerity.

But there is no guarantee that, as growth slows, people will continue to vote in favor of austerity. It’s also far from certain that the core of Europe will support more quantitative easing, which erodes the value of savings in thrifty countries like Germany. Failure on either of these fronts is likely to wreak havoc on the global markets.

So what should U.S. investors do? The answer is actually very simple. The prices of equity-index options on the SPDR S&P 500 ETF (ticker: SPY and the iShares Russell 2000 ETF (IWM) are generally much higher than options on currencies, such as the Japanese yen or Australian dollar. The prices reflect the higher implied volatility—or the expected sizes of day-to-day moves—of the stock indexes.

But what you should hedge against are the extremes, not the day-to-day movements. History shows that when the extreme occurs, stocks, bonds and currencies become highly correlated and the volatility gap narrows. So if currencies are likely to end up like equities during extreme scenarios, why not buy the cheaper assets today?

Look at call options on the Rydex CurrencyShares Yen ETF (FXY) which increase in value as the yen appreciates against the U.S dollar. Also, consider put options on the Rydex CurrencyShares Australian Dollar ETF (FXA), which rises in value as the Australian dollar rises against the greenback. Buying downside puts in the FXA expiring in six months and similarly dated upside calls in FXY will offer some protection to your portfolio if the sky does indeed start to fall. 

PATRICK NEAL is CEO and chief investment officer of TreePoint Capital Management.

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editors@barrons.com

By STEVEN ROSENBUSH

For investors looking to diversify into emerging markets, they might be surprised to know there’s more than stocks on the menu.

Instead, portfolio managers increasingly suggest emerging-market bonds as a viable alternative for investors looking to diversify their portfolios and earn higher returns than in developed markets.

“Emerging-market investors are generally more than 50% underweight in these [bond] markets,” says George Hoguet, a senior portfolio manager and global investment strategist specializing in emerging markets at State Street Global Advisors

.

Among the encouraging signs Mr. Hoguet and other portfolio managers point to: economic growth rates in countries like Brazil and Turkey that are four times those of the U.S.

Demand for certain types of debt is soaring. In the past 12 months, through April 16, the JP Morgan Emerging Market Bond Global Diversified Index, an index of emerging-market hard-currency debt, has returned 10.9% in dollars, while the JP Morgan U.S. Aggregate Bond Index rose 8.6% in the same period. Bonds issued in local currencies have lagged behind, though. The JP Morgan Government Bond Emerging Market Diversified Index, for example, has risen 0.57%.

Diversified Strategy

Some countries feature bond issues in both local and foreign currency. The latter, denominated, for example, in the U.S. dollar or Japanese yen, can be used to build up their hard-currency reserves, improve their balance between assets and liabilities, and support their local bond markets in general.

Mr. Hoguet favors a strategic allocation to both hard- and local-currency debt. An investor in local-currency bonds does assume currency risk, he says. But holding a portion of one’s wealth in a basket of foreign currencies is advisable, he says, as a portion of one’s consumption over time comes from foreign goods produced both in developed and emerging markets.

Mr. Hoguet recommends holding about 2% of an overall bond allocation in emerging-market hard-currency bonds, and about 8% in emerging-market local-currency bonds. For an overall allocation to emerging markets, Mr. Hoguet recommends 13% of equities be invested in emerging markets and about 10% of total bonds.

Another fan of emerging-market debt: Morgan Harting, senior portfolio manager and emerging-markets multi-asset team leader at AllianceBernstein Investments Inc., a unit of New York-based AllianceBernstein Holding

LP. Mr. Harting says he expects “much emerging-market debt will continue to outperform, although with more volatility.”

At the most basic level, Mr. Harting says, emerging-market debt offers investors higher yields than are generally available in developed markets. Yield to maturity on emerging-market debt as measured by the JP Morgan EMBI Global Diversified Index is roughly 5.37%, compared with roughly 2% for the U.S. 10-year Treasury bond.

The debt also can be used to limit volatility in the emerging-market portion of a portfolio, Mr. Harting says. In 2008, as a result of the financial crisis, emerging-market equity prices slumped 53%, he says, while emerging-market debt prices fell only 11%.

Back and Forth

When an investor likes a particular emerging market, and its debt market is strong, some advisers recommend alternating between local asset classes, depending on conditions. Mr. Harting, for example, likes Mexico because of its growth. But for now he says he can find only a few equities in Mexico that are well priced. So he has bought currency for growth and Mexican bonds for diversification.

In a riskier play, Mr. Harting also likes bonds of oil-rich Venezuela. Its debt has yields in the mid-teens—among the highest in the world. The nation’s political instability, however, suggests a real risk of default. So he hedges some of the risk with credit default swaps, a form of insurance.

Mr. Rosenbush is deputy editor of WSJ.com’s CIO Journal. He can be reached at steven.rosenbush@wsj.com.

A version of this article appeared April 30, 2012, on page R5 in some U.S. editions of The Wall Street Journal, with the headline: Emerging Markets: The Allure of Bonds.

Edited by CRISTINA LOUROSA-RICARDO

There are plenty of stupid investments you can make in this world. Stock in Pets.com and Washington Mutual didn’t work out so well. Nor did those Las Vegas condos. Some of the social media and Web 2.0 stocks flying high on Wall Street will probably follow suit.

But the most foolish investment of all may be right in front of you. And there’s a worrying chance you’re buying it.

The investment? Stock in your own employer.

According to data from the Employee Benefit Research Institute, only about 40% of employees participate in 401(k) plans that even offer the company’s stock as an option. Those employees are still investing from 16% to 19% of their plan portfolios, on average, in their employer’s stock. At the same time, they have been shrinking their overall equity exposure dramatically.

One dollar in your employer for every two dollars spread across all the other companies out there? It makes no sense.

First, you already have a big investment in your employer. You work there. If you are hoping to work there for some time, it may well be the biggest investment in your portfolio.

The value of an investment comes from its cash flow. Let’s say you’re hoping to earn a modest $45,000 a year for the next 10 years. An annuity producing that series of cash flows might cost you about $380,000. For 20 years: nearly $600,000.

No, a job and an annuity aren’t identical. But the analogy is useful. Your cash flow already gives you a huge stake in the company. Do you need to double down?

Legions of workers did just that and became two-time losers. Their employer collapsed. They lost their incomes and their savings at the same time. Think of Enron. Think of WorldCom. Think of all those who worked at banks that collapsed in 2008. Bank of America and Citigroup avoided bankruptcy, but their stocks fell to pennies on the dollar.

The second problem with investing in your own employer’s stock? It’s based on the theory that you’ll benefit from the company’s improved performance and that you’ll have incentive to contribute. You’ll be a stockholder as well as an employee, and you’ll think like one. Employees buying company stock think they will have some influence over how it does.

Good luck with that.

The theory is fine if you work for yourself, or in a small partnership. But in a company of 500 or 1,000? No matter how hard you work, you won’t have any material effect on the share price. The only people who can do that are the senior executives.

Speaking of whom: Many people who buy company stock think they’re following safely in the footsteps of top executives. But this, too, is an illusion. Even if the CEO holds $10 million in company stock, so what? His financial situation is totally different from yours. He may hold $50 million in other investments. If he gets canned, he may have a golden parachute and a network of golden handshakes to fall back on.

And are CEOs really investing in the company? Most just get free stock and options—which they then sell.

—Brett Arends, SmartMoney Magazine

Eye on Overdraft Fees

Bank overdraft fees are the latest target of the Consumer Financial Protection Bureau, which said last week that it would demand data from the biggest financial institutions and look at ways to make the fees on checking-account statements easier to understand.

This overdraft-fee campaign could eventually help consumers avoid unexpected charges.

The bureau said it will gather data “from several of the largest banks in the country to evaluate how those institutions’ overdraft policies affect consumers,” without specifying which banks were asked to supply data.

The American Bankers Association has said most bank customers don’t pay overdraft fees and that customers can avoid the charges by keeping extra money in their accounts or by linking checking accounts to savings accounts.

The bureau, however, said it’s concerned some banks may be charging and calculating the fees in a way that is misleading or confusing for consumers and that the banks aren’t consistently following previously outlined “best practices.”

—Maya Jackson Randall, Dow Jones Newswires

Bypass the 10% Penalty

Thinking about raiding your retirement funds? There are ways to do so without triggering the dreaded 10% penalty on early withdrawals for people under the age of 59½.

If you leave a company in the year in which you turn 55 or older, you can take penalty-free withdrawals from a 401(k) plan. (The distribution would be taxable, of course, but the 10% penalty would not apply.)

There also are ways to avoid a 10% penalty with an IRA.

IRA owners can take so-called 72 (t) withdrawals. Under their rules, you can start taking these withdrawals at any age. But once you start, you must continue for either five years or until you reach age 59½—whichever is longer. (You can do it with a 401(k) as well, but you must have left the company first.) Moreover, because the payments are calculated according to actuarial tables, you won’t be able to adjust the amounts.

IRA owners who are unemployed can take distributions from a SEP, Simple, Roth or traditional IRA to pay health-insurance premiums for themselves, a spouse and/or dependents. You have to have received unemployment compensation for at least 12 consecutive weeks among other qualifications, says Ed Slott, an IRA expert in Rockville Centre, N.Y.

—Anne Tergesen, Encore Blog, SmartMoney.com

Tooth Inflation

How sweet it isn’t.

The average gift from the Tooth Fairy dropped to $2.10 last year, down 42 cents from $2.52 in 2010, according to no less an authority than the Original Tooth Fairy Poll, which is sponsored by Delta Dental Plans Association.

“But the good news,” their PR folks hasten to add, “is she’s still visiting nearly 90% of homes throughout the United States.”

Some other data points:

• The most common amount left under the pillow by the Tooth Fairy is $1.
• Most children find more money under the pillow for their first lost baby tooth.

—Total Return Blog, WSJ.com—The Aggregator, edited by Cristina Lourosa-Ricardo, features news and commentary from The Wall Street Journal and other Dow Jones publications. Email: cristina.lourosa@wsj.com

Corrections & Amplifications

About 40% of workers were members of plans that offered company stock as an option, according to data from the Employee Benefit Research Institute. An earlier version misstated that about 40% of 401(k) plans offered company stock as an investment option.

—

Dan David was a one-time jewelry executive who didn’t know a word of Mandarin. Yet he helped unmask several frauds among the dozens of U.S.-listed China stocks that have burned investors in the last couple of years and has raised allegations against others. When the Securities and Exchange Commission filed civil-fraud charges in February against the chairman of China’s Puda Coal, its complaint cited a report that the 43-year-old David had put out at GeoInvesting, a financial-information Website focused on small-cap stocks and based in Skippack, Pa. Why weren’t investment bankers and other Wall Street pros able to do what he did? Why didn’t they listen to his warnings? And how are investors now endangered by efforts in China to shut off information sources for researchers like David? He explains below.

Barron’s
: How did you get into investment research?

David: I was a director of stores for Finlay Fine Jewelry, running the Lord & Taylor division. We had 88 stores across the country under my supervision. I met my GeoInvesting partner Majed Soueidan playing on a flag-football team. People said, “That guy works for himself. He made himself millions just trading his own money.” He never talked about it. But it ended up being the truth.

We developed a friendship and he asked me to come work for him. For two years he stayed after me to come run his business. At some point, I saw that leasing space in department stores to sell fine jewelry was going the way of leasing space to sell shoes. Stores all decided they could make a profit running the shoe sections themselves. Finlay offered me a promotion, but rather than taking it, I went back to Philadelphia and began working with Maj. He’s the driving force behind our fundamental research.

You guys had a small hedge fund. How did you start publishing research?

People kept calling us and asking about our research. We figured we’d start a Website where we’d put our research. It would save us time and provide information to the average investor–whom we wanted to reach out to. So in 2008, we launched GeoInvesting.com.

As a free Website?

It is mostly free and has a long bias. We’re investors at heart. We were noticing that for many micro-cap stocks, the companies’ financial data appearing on Bloomberg or Reuters was inaccurate. We would get with these companies and post their correct financial information on our site. Just a flow-through portal that would give attention to stocks that the major portals didn’t. For $9.99 a month, subscribers today can get risk-analysis reports on certain U.S.-listed China stocks and reports from our on-the-ground due diligence.

How did you first find your way to the U.S.-listed China stocks?

Some of the most egregious reporting differences were in the U.S.-listed China stocks. We dabbled in those stocks in ’06, ’07 and ’08. But 2008 was a horrible year, obviously, for a long investor, and our world was shaken along with everybody else’s. So we just put our noses to the grindstone and all these China stocks kept popping up to the top of the list. We went long the Chinese market in a big way.

Their fundamentals and valuations looked good?

In 2009, we picked up 229% in investing in China. Our portfolio was 80% in China–all long. We never shorted a stock. We made a killing on China MediaExpress Holdings (ticker: CCME). We got out of the stock not because we thought they were a fraud, but because they hit a valuation target.

Then some researchers challenged China MediaExpress’ claims about the size of its bus-advertising business?

We saw some of these short reports that research firms like Alfredlittle.com and Muddy Waters were doing. We decided right away that they were wrong. What we needed to do was invest some money in hiring our own team. We were going to go prove them wrong and bring that information back to our subscribers and to the investment community.

You started research to rebut the shorts?

We did just that. And what we came back with just rocked us to our core. Fraud was pervasive and out in the open. We would ask our investigators to go visit a facility and they found it wasn’t operating. I was shocked. We then approached our China attorney and asked for these filings that companies make to the SAIC, the State Administration for Industry and Commerce. In July 2010 we got filings on China MediaExpress. He charged us $5,000 for two filings that must’ve cost him a couple of hundred dollars. Then we realized we didn’t read Mandarin.

None of you?

Not at that time. When I called the attorney back, he said, “Okay. We can translate them for you for another $5,000.” So we fired him.

After you hired your own lawyer and translator, what did you do with the information?

We didn’t know what to do with China MediaExpress. We just stayed away from it. Some six months later, China MediaExpress’ auditor and some directors resigned. It stopped reporting to the SEC.

So we started pulling more and more SAIC filings. We took what we found on the cemetery-operator China Redstone Group (CGPI) and the drug maker Lotus Pharmaceuticals (LTUSE) directly to their investor-relations firms and to the companies themselves. We said, “Here is what we found. We have no position in your company. We are not long. We are not short. We want to help you fix it.” We hoped they’d make the corrective disclosures and mention how we helped them. Investors would ultimately reward their honesty.

Did they appreciate the information?

They tried to convince us we were wrong.

With Lotus Pharmaceuticals, they had indicated that they spent $32.7 million on land in Inner Mongolia. We had an independent appraisal done on the land and it appraised for less than $7 million. With China Redstone, they said they owned a cemetery. They didn’t own it. They didn’t have a license to operate it. We had government documents that showed that it was owned by another entity. We sent our guy there and we bought cemetery plots. Lo and behold, the receipt for the cemetery plots had a different company’s name on it, and the prices were different from what they said they were selling cemetery plots for. They sent us a letter of cease and desist.

Did you desist?

No. We said that we will appeal to the investment community, still not taking a position long or short.

We released our findings on both Lotus and China Redstone. And the investor community hated us. They said we were short sellers and didn’t care if we said we weren’t.

Lotus later returned its Mongolian assets to the previous owner for no cash, and recently said that it can’t afford to employ an auditor. It has stopped reporting to the SEC. China Redstone’s chief financial officer resigned, and it, too, has stopped reporting to the SEC.

Nobody appreciated your work?

We had just spent $50,000 and we made no money because we didn’t trade it at all. Nobody wanted to hire us from the investment-banking community. Their answer was: “How does this help us? We can’t collect fees from this company if we think they are a fraud.” The investor-relations firms kind of felt the same way: “I can’t represent them if I take you at your evidence and consider them a fraud.”

Our information was accurate, truthful, and from public records, so we finally decided that we might as well start selling these stocks short–as we were entitled to do. We have no long or short positions now in any of the stocks I’m discussing here, by the way.

When did anyone start paying attention?

People started taking our research seriously when we released a story on Subaye (SBAY), a cloud-computing company that claimed to have 1,539 employees at a certain location. We sent our investigator there.

What did he do?

He stood outside for two days and watched the employees come in and out. Then he called and said, “There’s a problem. They have many fewer employees there than they claim.” And I said, “Okay, they say they have about 1,500. What are we looking at, half that?” And he said, “No, 40 to 50.” The investigator also talked to the community at large. The local people would tell you, “You are not here on the wrong days. This is really how many people come in and out of there.” So we published that report and Subaye got delisted. The CFO resigned.

In February 2012, the SEC cited your report when it alleged that the chairman of Puda Coal (PUDA) had looted the company and left shareholders with an empty shell.

Puda’s Chairman Zhao Ming transferred ownership of the business to himself and then pledged 49% to the government-owned Citic Trust—all prior to [securities firms] Macquarie and Brean Murray, Carret raising $100 million from U.S. investors. If Macquarie had pulled an SAIC filing worth a few hundred dollars, I would like to think they wouldn’t have done that fund raising. Puda’s audit committee confirmed the allegations of wrongdoing. Puda’s been delisted. In a couple of weeks, the underwriters will file their responses to a shareholder suit in Manhattan’s federal court.

Unfortunately, Zhao is still a billionaire. He hasn’t answered the SEC and drives around Hong Kong in a Bentley with the license plate PUDA.

Is it now getting harder to check the SAIC records that exposed these frauds?

It’s changed in two ways. SAIC filings can be amended. So most companies have gone back and amended their filings to match the SEC filings in the U.S. There is nothing on the SAIC document that says “amended version.” The only way you know now that an SAIC filing has been amended is if you had pulled a copy previous to its being amended–which is why I have thousands of them.

What’s the other change?

I hear they are requiring you to get a “statistics license” to do investigations in China—at the risk of criminal charges.

So is GeoInvesting going to be able to get a statistics license?

I sincerely doubt it. Make no mistake, GeoInvesting will get around it. But I don’t think anybody is going to give us a license.

Has research gotten harder to do in unofficial ways?

SAIC employees now ask who you are and why you want these filings. Then they alert the company.

Have you ever had any of your people hurt?

I’ve had a person on my team that was compromised when viewing a company and was beaten up. Thrown down. Hit in the head a few times…that kind of a thing.

Did he keep working for you?

Yeah that one did. He is a good guy. He was near enough that security could see him lingering and making a truck count. Security was just doing their job, I guess. I’m thankful that they didn’t harm him severely.

Any other troubling trends for investors in China?

Just the longstanding moral hazard posed by the VIE structure that so many of these companies use.

You mean the “variable-interest entity” arrangement in which U.S. investors don’t really have an ownership in the Chinese businesses?

The VIE is a contract structure between a Chinese company and the investor that allows this entity to be listed here in the U.S. They agree to share the business’ profits with the foreign investors. But the contract can be canceled at any time by the executives of this company. And they would break no Chinese law in doing so.

These VIEs include huge companies, by the way, such as Internet giants SINA (SINA) and Baidu (BIDU). The argument defending VIEs is, if the managers own 20% of the listed shares here in the United States, they have a vested interest just like other U.S. investors. The moral hazard is, what happens when keeping 100% of the profits in China is worth more than the 20% stake in the U.S.-listed entity? There is no Chinese law that says you can’t get away with canceling this VIE contract.

Is GeoInvesting ever going to make a profit from its research and Website?

You can make money on subscriptions for parts of the site that are more valuable. You can make money on advertising, once your site has enough traffic. Nobody is helping the common person. Short sellers don’t necessarily care to inform the common person until the last minute. The fee collectors in New York only care about the fees they are collecting and want to continue to collect. The whole idea behind GeoInvesting is to try and put investors nearer to a level playing field with the big funds by giving them research.

Let’s hope it works. 

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