A Portfolio That Beats the Market
Hedge funds are in the financial headlines all the time. Most people believe hedge funds are only for the wealthy and for institutional investors, such as pension funds and foundations. That’s not really the case. In fact, regular investors have better options than most of the hedge funds that are out there. You can receive most of the benefits of hedge fund investing without paying the high fees they charge.
For years I’ve put together a portfolio of no-load, reasonable expense mutual funds that use the investment strategies traditionally used by the best hedge funds. They aren’t restricted to buying a particular type of investment, such as stocks or bonds. They follow different investment strategies with returns that aren’t tied to the stock market, and many of the strategies have less risk than stocks.
Hedge funds don’t all follow the same investment strategy. The best hedge funds, however, tend to follow one or more of several successful strategies. Some are distressed investors; they buy beaten-down assets they believe have much more value than their current prices. They might specialize in a particular asset class, or they might look for the best distressed opportunities. Others are “macro investors.” They look for major trends and try to profit from them. Others use tactical asset allocation. They adjust the investments in their portfolio so they own the best values or those with the strongest trends. Some use a flexible “go anywhere” strategy. They can buy stocks, bonds, or other securities in any market. They can sell short. They can use options or futures contracts to hedge or leverage an investment.
The real advantage to a good hedge fund is that its returns are not closely tied to the major stock and bond indexes. Most mutual funds do well when stocks in general are rising and poorly when the indexes are falling. Except at the beginning of a long-term bull market you are better off with investments that can make money independent of how the stock indexes are doing.
Because of their unique strategies, good hedge funds can do that.
There are plenty of hedge funds out there, plus funds of hedge funds. Most of them, despite all the publicity about billionaire hedge fund managers, don’t deliver very good returns, especially after adjusting for risk. Some earn positive returns only because they use a lot of leverage, or debt, to increase the modest returns they earn. In addition, picking one or two hedge funds is not the right strategy. Every hedge fund’s strategy will be out of favor at different times. You want to select funds that can limit their losses during these times. You also want to select a portfolio of hedge funds that complement each other so that different funds in the portfolio are doing well at different times. That gives the portfolio a fairly steady rate of increase without the dramatic losses incurred by traditional portfolios.
At Retirement Watch we uncovered mutual funds that use typical hedge fund strategies and have done so successfully for some time. We also combined the funds in a portfolio so they compliment each other.
Our portfolio of mutual funds that use traditional hedge fund strategies is lags the S&P 500 in stock bull rallies but beats it during flat or down markets. Over longer periods the portfolio earns much higher returns than the index while taking less risk.
Because the funds use different strategies, their returns are not closely correlated with each other. During some extreme times, all of the funds are rising or falling. Most of the time, however, some funds are doing well while some are out of line with market trends. This diversification and balance makes the portfolio’s overall returns more stable than those of traditional portfolios and market indexes. All of the funds do quite well over time. The true diversification also allows the portfolio to earn higher returns than the S&P 500 over time with less volatility than the index and far less downside risk than a traditional portfolio.
The diversification also means the portfolio can earn positive returns when the stock and bond indexes are not doing well. Occasionally, all investments decline as in 2008 and early 2009. But the diversification means we earn higher returns than the S&P 500 most of the time, lose less in downdrafts, and recover the losses more quickly. Unlike the S&P 500, the portfolio already made up the losses from the bear market and has positive returns for all periods. Only three funds in the portfolio haven’t made up for their bear market losses and still have negative returns for three years.
Here’s a sample of the “hedge fund” mutual funds in the portfolio.
Hussman Strategic Growth owns a portfolio of about 150 stocks. The fund analyzes current market valuations and climate, and then uses options contracts to either leverage the portfolio to enhance bull market returns or to hedge the portfolio against a market decline.
Third Avenue Value is a classic distressed or deep value investor that can purchase almost any security. Manager Martin Whitman and his team rigorously examine a firm’s balance sheet and look for assets that are worth substantially more than the stock market value. The fund also will buy preferred stock or bonds when those offer a big payoff.
The portfolio has some unique asset allocation and balanced funds such as PIMCO All Asset,
I generally don’t like buy-and-hold investing, but I make an exception for this hedge fund portfolio. Most of the fund managers have discretion to move in and out of assets (or increase cash). They manage for the market changes so we don’t have to.