How to Gain Equity Exposure with Reduced Volatility

Most investors out there follow the basic premise that Modern Portfolio Theory, Random Walk and/or Buy and Hold is the best way to invest. Diversify a portfolio and let it ride. Steadily add to your investments and you'll do fine. Well, that's been a painful way to invest for well over a decade and most of the followers of these ideas do not realize that they're adhering to these strategies while taking outsized risks. The volatility over the prior 10 years has been gut wrenching at times and in most cases it hasn't gotten you anywhere. I don't think this is the time to throw MPT, Random Walk or Buy and Hold out the window as so many investors are doing - the time for that was 10 years ago. With the market off its highs by over 40% this is no time to declare those strategies dead. More likely, it's the time to be implementing them.

Over time more and more absolute return portfolios are hitting the market. Index funds and changes in mutual funds are providing fantastic ways to reduce your volatility and implement some of the more creative strategies that professional investors use. Your portfolio doesn't have to be that ship getting tossed around in the sea. Today, you can control whether you navigate the Pacific by dingy or by oil tanker. There's no need to invest in the markets while making yourself vulnerable to the 5%+ weekly moves we tend to be seeing these days. So how can you diversify your portfolio in a way that reduces the overall volatility, but doesn't turn your portfolio into a boring old bond or money market fund?

Naturally, the best way to try to obtain equity-like returns without taking the risk involved in equities is to shift into other asset classes or use equity derivatives. Two of the more creative ways to attain equity-like returns without enormous risk are via funds such as DBV and PBP. DBV is a currency fund that implements a relatively rational strategy. It shorts currencies with low interest rates and buys currencies with high interest rates based on the expectations that currencies with low interest rates tend to become devalued while high interest bearing currencies tend to appreciate. As you can see, the fund has navigated some very turbulent times with greater than equity returns and reduced volatility.

Another interesting index fund is the PowerShares S&P 500 BuyWrite portfolio (PBP). The fund implements a traditional buy write strategy, i.e., it buys the S&P 500 and writes covered calls on the underlying. Buy/Write strategies tend to perform more or less in line with the S&P 500 without the added volatility.

The mutual fund industry is also making enormous strides in the alternative investments world. John Hussman has long run a long/short option strategy (HSGFX) that has substantially outperformed the S&P 500 since its inception in 2000 - particularly impressive considering the horrible timing of the funds inception. Despite the turbulent market the fund is up 8.5% per year vs a -6.4% annualized return for the S&P 500.

The Nakoma Absolute Return Fund (NARFX) is another long/short bond and equity fund with a short history, but very impressive performance in a horrible market. The fund was started in December of 2006 and has a 4.7% annualized return vs a -23% annualized return for the S&P 500.

The Fund seeks to achieve its objective by selecting investments intended to provide protection of capital in declining stock and bond markets and to participate in appreciating stock and bond markets. The Fund invests primarily in equity securities traded in U.S. markets taking long positions in companies where the Adviser believes operating results will exceed investor's expectations and establishing short positions in companies the Adviser believes will disappoint or as hedged offsets to long positions.

Rydex has been at the forefront of the alternative asset class move in the mutual fund industry and provices some of the very best ways to obtain equity-like returns with relatively low volatillty. They have a number of different funds and fund of funds that invest in absolute return strategies, managed futures and other strategies that reduce market correlation while creating value. The funds I would look into include RYMFX, RYFOX, RYSTX, RYGHX, RYEPX & RYMLX.

RYMFX is a managed futures fund that invests in commodity, currency and financial linked instruments whose performance is expected to correspond to that of the underlying benchmark. RYSTX is a long/short fund that seeks capital appreciation consistent with the return and risk characteristics of the hedge fund universe. The secondary objective is to achieve these returns with low correlation to, and less volatility than, equity indices. The fund normally invests at least 80% of assets in US and foreign securities of any capitalization range, or derivatives including futures, options and swap agreements. It pursues a long/short investment strategy by employing multiple investment styles widely used by hedge funds.

RYFOX, RYGHX, RYEPX, & RYMLX are funds of funds that invest in various Rydex funds that implement strategies ranging from the managed futures fund to 2X equity funds.*

*Some of the funds mentioned above have higher than average expense ratios and investment minimums. Please consult the fund prospectus and/or your financial advisor before making any investment decisions.

Disclosure: No position in funds mentioned.

Comments

[trader25:]

Great post, thanks.

2008 Dec 29 04:21 PM