Investing Outside the Box

Making your money work for you in a challenging environment

By: Kimberly Palmer

Making money through investments hasn’t been easy lately. Real estate is down. The stock market’s down. Bonds aren’t paying much beyond what you’d get by storing the cash in your basement safe.

As a result, more investors are turning to strategies not usually seen in the mainstream markets, from mutual funds that bet on the future prices of commodities to funds that trade on the value of companies that might merge—a technique that insiders call merger arbitrage.

The popularity of these “alternative investments” has skyrocketed in recent years; Morningstar reports that $10.5 billion flowed into such funds in 2009, more than five times the amount in 2005.

They’re not just for the wealthy anymore. “Ten years ago, you needed a million dollars to get into this. Today these strategies are available to the average investor,” says Barry Glassman of Glassman Wealth Services in McLean. Many new funds require minimum investments of only $1,000.

After experiencing steep losses in 2008 and 2009, many investors sought options beyond cash, stocks, and bonds, says Glassman.

“Prior to the Great Recession, people thought diversification meant buying foreign stocks, smaller companies, and bonds,” he says. “They learned the hard way that that didn’t diversify their portfolio.”

While many financial advisers recommend sticking with those traditional diversification strategies, others suggest turning to vehicles that don’t move in sync with the stock market. Alternative investments fit that bill because they take both “long” and “short” positions, meaning they bet on prices going up as well as down. Hedge funds and private-equity funds have long met this demand for the super-wealthy.

Over the past several years, Rockville-based Rydex SGI launched a series of alternative funds, including its flagship Managed Futures Strategy fund, which tries to anticipate fluctuations in the prices of commodities and global financial futures, such as currencies.

“These funds won’t necessarily react to equity or interest-rate movements,” says Marc Zeitoun, a managing director at Rydex SGI. “They have their own drumbeat.”

“I can’t think of one portfolio that wouldn’t benefit from alternative investments,” because of their diversification benefits, says Nadia Papagiannis, alternative-investment strategist for Morningstar. According to her analysis, the average long/short mutual fund lost about 25 percent between early October 2007 and early March 2009. The S&P 500 lost about 55 percent over the same period. Investors also want to compare the funds’ expenses—long/short funds tend to carry slightly higher expense ratios than traditional funds, though the ratios vary.

For investors interested in venturing beyond the traditional path, what follows is an overview of some of the most popular options.

But not everyone is a fan. Nathan Gendelman, director of investments at the Family Firm, a fee-only financial-planning firm in Bethesda, steers his clients away from alternative investments, largely because he doubts many will produce positive returns over the long term. With managed futures, for example, he says you’re neither loaning money to a productive company nor investing in one. Instead, you’re using a formula to buy something when the price goes up and to sell when the price goes down.

“There’s nothing in these that’s really an investment,” he says. “What’s the difference between that and spinning a roulette wheel?”

Gendelman also notes that because many alternative investment methods are so new, they lack a sufficient track record.

Aimee Daniels, regional president for the Mid-Atlantic at HSBC, says alternative investments are still unusual for anyone but the wealthiest clients.

“They tend to be technical enough that you need someone to walk you through it,” she says. “How does it work? Does it lock up your money? How does it match your overall goals?”

Instead of exploring such uncharted territory, many of Daniels’s clients are taking their money out of the stock market and using the cash to pay off mortgages or refinance to take advantage of lower interest rates.

“We’ve seen a lot of people saying, ‘I don’t want to have debt right now,’ ” she says.

>> Next page: Still interested in alternative investments? Here’s what to know about the various types

Managed Futures
For the past few years, Bernie Wolfe of Bernard R. Wolfe & Associates in Chevy Chase has suggested that some of his clients invest a small portion—no more than 5 to 10 percent—of their portfolios in managed futures, which take long and short positions on the future prices of everything from commodities to currencies.

“If the market’s not the place to be, you need a combination of strategies,” Wolfe says.

For investors with less than $10,000 to invest, mutual funds such as the Rydex Managed Futures Strategy fund—which has a minimum investment of $1,000 for retirement accounts and $2,500 for other brokerage accounts—offer an easy way to put money into managed futures. The fund has returned an average of 0.43 percent since it started in 2007.

Investors with at least $10,000 to invest and a net worth of at least $250,000 (excluding their home), or at least $75,000 in net worth and $75,000 in annual income, can put their money in Rockville-based Steben & Company’s Aspect Global Diversified Fund, which launched in September 2008 and is accessible through financial advisers. It invests in the futures contracts of currencies, stock indices, energy, metals, interest instruments, and agricultural commodities. It ended 2008 up by 24 percent, just as the rest of the market was tanking, largely because the fund shorted energy and stock indices. Then, in 2009, it fell by 18 percent as the market recovered. Through September 2010, it had a gain of 8 percent.

“Historically, investing in managed futures has reduced the risk in an overall portfolio,” says Steben principal Neil Menard.

Steben offers other funds for individuals and institutions with higher net worths—typically, at least $1 million, exclusive of homes—but details about those funds are not public and Menard declined to elaborate.


Long and Short Stock Funds
These funds take both long and short positions in US stocks, meaning they can benefit from market gains as well as losses. The Hussman Strategic Growth Fund, run by John Hussman out of Ellicott City, invests in companies with the potential for long-term growth while shorting broad indexes, which provides protection during market dips. In 2008, when the S&P 500 fell by almost 40 percent, the Hussman Strategic Growth Fund dropped by just 9 percent. Since Hussman started the fund in 2000, it has returned an average of almost 8 percent a year. The minimum investment is $1,000, or $500 for IRAs or gifts to minors.

 
Absolute-Return Funds
These funds are designed to provide returns with limited volatility, no matter what the market conditions, by taking a careful calibration of long and short positions.

“You’re trying to generate positive performance regardless of what happens in the broader markets,” says Scott Welch, senior managing director at Rockville-based Fortigent, which provides investment research to financial advisory firms serving wealthy families.

It sounds too good to be true, and in a way it is: Many of these funds have failed to deliver on their promise, while providing some buffer against dips. Rydex’s absolute-return fund, the Rydex SGI Multi-Hedge Strategies Fund, is down by about 3 percent since it started in 2005. It invests in a variety of alternative strategies, including long and short equity investments, global currencies, and merger arbitrage.

Despite the spotty performance, Welch says, “people are beginning to invest more in the absolute-return space than they probably ever had before,” largely because it’s so easy to do. Even people with enough net worth to invest in private funds often prefer publicly traded mutual funds, which provide greater liquidity—you can take your money out almost immediately if you want to—and are subject to regulatory oversight.

While those restrictions often put a damper on the funds’ performance, Welch says that post-2008, many investors are happy to make that trade-off. He prefers to call the strategy “diversified alternatives” instead of “absolute returns.” The Rydex SGI Multi-Hedge Strategies Fund requires a minimum investment of $2,500 for non-retirement investment accounts when bought through firms such as Fidelity.


Hedge Funds, Private Equity, and Venture-Capital Funds
Accessible only to the super-wealthy, these funds generally require investors to lock up $1 million or more of their assets, which are then combined with other funds to invest in securities, companies, and start-ups. They often use complex strategies that are hard for anyone but the most experienced investors to understand. While their role in the real-estate meltdown of 2008 gave these funds a bad rap, many wealth managers say they still have a valuable role.

Jeffrey Dillman, a managing director at Atlantic Trust, a private-wealth-management firm where clients’ assets range from $2 million to $50 million, uses hedge funds to generate returns for some of his higher-net-worth clients who can afford the high minimums, which are often $5 million and up.

“Hedge funds have done a pretty good job of outperforming the market in difficult times,” he says. “They underperformed in the recovery, but the ride has been smoother.”

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