Advice: Investing & Portfolios   A Buy-and-Hold Portfolio That Holds Its Value   The Holy Grail for most investors is a buy-and-hold portfolio that serves them well in good markets and bad. They want a portfolio that doesn't need to be adjusted for different economic and market environments. At Retirement Watch we're very close to that Holy Grail with our portfolio of "hedge fund" mutual funds. The portfolio is passing the demanding test of the 2011 investment markets and continues to meet our goals. This buy-and-hold portfolio has true diversification, so it reacts well in almost all market environments. It earns solid returns in good markets and holds up very well in bad markets, avoiding large losses and sometimes rising in value when major indexes decline. The portfolio extended that pattern in the recent market havoc. Traditional portfolios have about 70% to 80% or so of their returns and volatility attributable to the major stock market indexes. That’s great in a roaring bull market as we had from 1982-2000, but it damages your retirement goals in periods like this. Let’s look first at how the portfolio performed long term, and then take a close look at the numbers from the recent turmoil.

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Stock markets around the globe lost ground in the quarter ended June 30, but the hedge fund portfolio generated a positive return of 1.26%. Only one fund had a negative return for the quarter, our most aggressive stock-oriented fund. For one year the fund return 14.24%. That’s a solid return but a significant lag behind the stock indexes, which is what we expect during strong stock market rallies. The true diversification in the portfolio allows us to keep the returns when stocks falter. For example, over three years the portfolio has an annualized return of 5.57%, and over 10 years the annualized return is 8.36%. Its annualized return over the S&P 500 during the longer periods is substantial.

A key to this performance is that the portfolio is not highly correlated with stocks.  The hedge fund portfolio has a beta of only 0.55 to the S&P 500 over the last three years and only 0.45 over 10 years. Beta is a way financial wonks measure an investment’s correlation with an index. A beta of 1.0 means an asset rises and falls perfectly in line with the index. A low beta to the S&P 500 shows we have true diversification. We had a lower beta before the financial crisis and the ensuing monetary stimulus increased the correlation of investment assets, but the portfolio still manages to separate itself from the index. Despite the low beta, the portfolio has higher returns than the S&P 500 over most periods, and this is after the strong returns of the index over the last three years. We accomplish this by diversifying among both assets and strategies. That helps us avoid participating in the index’s deep down drafts. In short, we’ve found no-load, low expense mutual funds that use strategies of the best hedges funds instead of traditional mutual fund strategies. Our equity-based funds aren’t straight index funds. They have important differences from the index that generate higher returns than the indexes long term. These funds are deep value investors who can go anywhere on the globe and invest in most types of securities. They buy primarily stocks, but they also can buy bonds, convertible securities, and hybrid securities. They can raise cash (which they’ve had high levels of recently), and one can sell stocks short.

The managers look for assets selling at significant discounts to the true value calculated by the managers. Lately, they’ve been buying primarily stocks outside the U.S., especially Asia.

We also own real estate investment trusts. Since the financial crisis, these largely rise and fall with the S&P 500, but they’re more volatile than the index, rising much more in rallies and declining more in sell offs.

High-yield bonds generate high income without the interest rate sensitivity of treasury and corporate bonds. Their yields also make them less volatile than stocks. Their long-term returns usually are equal to or better than the S&P 500’s. They’re most vulnerable in recessions when risks of defaults rise. I recommend the two most conservative high yield bond funds, because they avoid the riskiest bonds and the biggest losses. Each has lost value since the stock market peak, but far less than the stock indexes. Their yields currently are between 5% and 6%.

We hold a hedge against the dollar through international bonds. The fund tends to rise and fall primarily with changes in the dollar’s value, with a small amount of interest income and also capital gains or losses from interest rate changes.

The portfolio also has a unique balanced funds and several asset allocation funds that allow the managers to shift their portfolios among different assets to capture the best market opportunities or reduce risk.

One fund switches between stocks, bonds, and cash. Its preference is to buy high-yield bonds or distressed securities. But it also buys other types of bonds and stocks when the management locates values and will hold a lot of cash when values aren’t apparent. Another has a similar strategy and profile and recently amended its guidelines to allow investments in gold. Despite their similar styles, the funds generally have very different holdings. Another of the asset allocation funds moves the portfolio among most of the funds available from its fund family. Rounding out the portfolio is a fund that uses a classic hedge fund strategy of owning stocks and using options to leverage or hedge the portfolio.

The hedge fund portfolio continued to deliver on its goals during August’s market slide. For the one-week period ended with the close on August 8, the portfolio lost 5.02% compared to 12.96% for the S&P 500. For the four weeks ended the same date, the fund lost 5.93%, compared to 16.61% for the index. Two funds rose in value during those periods. Two of the stock funds had the largest losses in the portfolio, and the other funds declined, but by much less than stock indexes.

Higher long-term returns with less volatility are the goals of this portfolio, and it’s meeting them. It loses much less than the stock market indexes in downturns, but generates gains most of the time. That’s how we achieve higher long term returns than stocks with less risk.

RW August 2011.

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