By Brett Arends
Should you adopt a few hedge-fund strategies in your
portfolio?
At first blush the idea seems perverse. Hedge funds are on track
for another mediocre year. The average such fund has underperformed
a plain-vanilla 60-40 mix of stocks and bonds, as tracked by
products such as the Vanguard Balanced Index Fund, in each of the
past five years.
Yet there might be a case for considering something more
exotic.
Equities and fixed-income markets have become increasingly
expensive. This raises the risk that future returns from such
mainstream investments won't be as good as they have been in the
past.
Meanwhile, new research by strategists at Société Générale unit
SG Securities, conducted on behalf of its institutional clients,
has found that adding a dose of "alternative" strategies to a
mainstream portfolio of stocks and bonds would have boosted returns
going back to at least the mid-1990s. They also lowered volatility,
or sharp swings in value.
The strategies included betting on the carry trade, which means
borrowing in currencies with low interest rates and lending in
those with higher rates, or betting on the price difference between
the current "spot" price for commodities and the price for delivery
at some future period, or on the likelihood that low-risk stocks
will outperform higher-risk ones.
Not only did the strategies perform well in their own right, but
in many cases they produced returns that were uncorrelated with
stocks and bonds, meaning they tend to zig when most of your other
investments zag.
Shifting 10% of a traditional portfolio of stocks and bonds into
a diversified basket of 10 such strategies added about one
percentage point a year to returns, while shifting 20% of the
portfolio added two percentage points, according to SG. In both
cases the portfolios then experienced lower volatility, because
many of these strategies are uncorrelated with stocks and
bonds.
Some of these strategies produced surprisingly strong returns
with low risk. SG found that the popular carry trade has produced
excess returns over that of government bonds by six percentage
points a year since 2002--with very little volatility.
"These are the true diversifiers in the portfolio," says Mark
Wilson, chief investment officer at the Tarbox Group, a wealth
adviser in Newport Beach, Calif., with $420 million under
management, which has used such strategies for clients on
occasion.
The problem, as so often, comes when you try to put this into
practice.
Many of these strategies are so complex and involved they could
be pursued only by professionals operating at a hedge fund or an
investment bank. Even the most basic would require a fair amount of
expertise and work. Meanwhile, hedge funds bring their own problems
for investors. Not only are they mostly accessible to
high-net-worth investors, but they typically entail high fees which
will soak up a large portion of your profits--assuming the funds
are profitable.
Some mutual funds seek to offer these strategies for retail
investors. After the 2008 financial crisis a number of funds
labeled "absolute return" or "total return" sprung up with the aim
of providing uncorrelated returns.
They are a mixed group. "There are many total-return funds out
there that seem to be charging a premium for doing nothing other
than stocks and bonds," says Marc Roland, investment manager at
Dean Roland Russell, a wealth-management firm in San Diego that
oversees $210 million.
Lipper's index of absolute-return mutual funds--which use a grab
bag of strategies--has produced annualized returns of 3% over the
past five years, compared with 16% for the S&P 500 and 11% for
the Vanguard Balanced Index Fund. Many have fees approaching 2%,
many times that of low-cost index funds.
Some lower-cost focused products target a specific strategy.
Often these are exchange-traded notes, which are contracts issued
by an investment bank that promise to mimic the performance of a
particular index.
Stephen Craffen, a portfolio manager at Stonegate Wealth
Management in Oakland, N.J., which has $140 million under
management, frequently allocates 10% of client portfolios to the
iPath S&P 500 Dynamic VIX ETN. The ETN tracks the Chicago Board
Options Exchange Volatility Index, or VIX, which typically spikes
when the stock market hits turmoil.
A portfolio composed of 90% in the S&P 500 index of U.S.
stocks and 10% in the iPath S&P 500 Dynamic VIX ETN has
produced higher returns with lower volatility than 100% allocated
to stocks, Mr. Craffen says. The ETN charges fees of 0.95% a year,
or $95 per $10,000 invested.
A few of the strategies highlighted by SG Securities can be
accessed through low-cost exchange-traded funds. For example, some
of the most successful historically have been to bet that certain
types of stocks will outperform others over the medium to long
term. Types of stocks typically favored in these strategies have
included "value" stocks--meaning those inexpensive in relation to
fundamentals such as profits and net assets--"low volatility," or
low-risk, stocks, and "high-quality" stocks, meaning those of
companies with strong fundamentals and persistent profits.
Ordinary investors today have access to a plethora of low-cost
exchange-traded funds that invest in value, low-volatility or
quality stocks. These include the iShares MSCI USA Quality Factor
ETF, with fees of 0.15%, and the SPDR MSCI EAFE Quality Mix and
SPDR MSCI Emerging Markets Quality Mix ETFs, each with fees of
0.3%, which invest in developed and emerging overseas stock
markets, respectively.
Still, advisers say, investors thinking about adding alternative
strategies to their portfolio need to ask themselves, and their
money managers, some hard questions first. Do you really understand
why you are investing? Do you understand the strategy, the fees and
the risks? Are you investing in strategies in the hope of boosting
returns or simply reducing volatility?
Those adding more complex or more volatile strategies need to
tread carefully and do their homework.
Advisers typically recommend adding no more than around 10% of a
portfolio to higher-risk alternative strategies, such as betting on
volatility.
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