Higher returns with less risk is the holy grail of many investors. One way to achieve that is by investing in high quality hedge funds (not pre-packaged funds of hedge funds or mediocre hedge funds). Another way to do that, which has been profitable to my subscribers for some time is to invest in a portfolio of mutual funds that use traditional hedge fund strategies.
You may think hedge funds are very risky investments available only to wealthy investors and institutions, such as endowment funds. That’s a misconception. A range of strategies are available from hedge funds, and many of them aren’t very risky. More importantly, when you match a number of strategies in a portfolio, the portfolio is less risky than a traditional stock and bond portfolio.
A hedge fund strategy is one whose returns are not closely correlated with the major stock and bond indexes. It can earn positive returns when the indexes are sinking. Most investors are “long only” investors. Their returns are closely tied to the stock indexes, even when they think they are diversified. A “hedge fund” portfolio can hold value or even appreciate when traditional portfolios are sinking with stock indexes.
Many people don’t realize hedge fund strategies are used by some no-load, reasonable expense mutual funds. We put such funds together in our hedge fund portfolio. Most of the funds tends to have a low correlation with stock indexes. In addition, the funds have a low correlation with each other. Those factors give the portfolio true diversification. Most of the time some parts of the portfolio are rising while others are falling or stagnant. The result is fairly steady long-term returns instead of the wild fluctuations of traditional stock and bond portfolios.
My portfolio of “hedge fund” mutual funds tends to trail the S&P 500 in bull rallies but beats the index in flat markets and bear markets. The result is a higher long-term return than the index. The excess returns in down markets are substantial, as shown by the portfolios 9.21% edge over the index in the three months ending June 30, 2010, and 11.16% edge annualized over the previous three years. While the S&P 500 earned a negative return over 10 years, the hedge fund portfolio has a positive return of 8.72% annually.
Those returns tell only part of the story. The portfolio has less risk than the S&P 500, because of its diversification. One measure of risk is standard deviation, or volatility. Over 10 years, the standard deviation is only 8.08 compared to the S&P 500’s 16.19%. Over three years the portfolio’s 11.97 standard deviation is less than the index’s 20.78.
A measure of risk-adjusted return above the S&P 500 is called alpha. The portfolio’s annualize alpha is 5.79 over three years and 7.26 over 10 years.
It’s important to view this investment as a portfolio and not try to pick out individual funds. We earn these results with a buy-and-hold approach because the funds work so well together.
What are the hedge fund strategies?
We own a fund that invests primarily in stocks but can use options to hedge the portfolio when poor markets are anticipated or to leverage the portfolio when good markets are anticipated. Of course, partial hedging and leverage is possible.
Several funds use tactical asset allocation. They change the portfolio allocation between stocks, bonds, and cash based on valuations and other factors. One fund uses tactical asset allocation among a much wider range of assets.
Several other funds are distressed value investors. They look for securities (whether stocks, bonds, or hybrids) that are selling at a fraction of the value of the assets backing them. They also can raise cash when they can’t find enough investments that meet their standards of value.
The portfolio has several balanced funds that are far from traditional conservative balanced funds. They use a combination of value investing and tactical asset allocation to venture into assets and opportunities that other balanced funds won’t touch. The result is higher returns with less risk than the competition, plus a low correlation with major market indexes.
Rounding out the portfolio are special asset classes: high yield bonds, real estate investment trusts, and international bonds (as a hedge against the dollar).
One of the insights of modern portfolio theory is that assets that are risky by themselves can be combined into a less risky, higher returning portfolio when the return patterns of the assets are not correlated with each other or the major market indexes. To achieve this result you need to venture from conventional mutual funds and investment strategies. You can achieve higher returns with less risk by using strategies the best hedge funds have used for decades.
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