Hedge Funds Without Fees, Disappointments

You might have read about the disappointing recent returns from hedge funds. Over the last few years, wealthy individuals and institutions poured money into these investment vehicles in search of less volatility and the potential for high returns. The results for the last year or two have been disappointing to many of these investors, and hedge funds are closing down at a steady rate.

Yet, you won’t hear complaints from the readers who follow our hedge fund portfolio. This Alternatives Portfolio consists of a select group of mutual funds that follow investment strategies similar to those used by the best hedge funds. When the funds are grouped together as a portfolio, the portfolio achieves higher returns than the S&P 500 with less volatility.

The quarter ended June 30 was another winner for the portfolio. It returned 1.57%, which compares favorably to the S&P 500’s 0.20% gain for that quarter. The Alternatives Portfolio also beat that stock index over one-year, three-years, and 10-years. Only over five years has the S&P 500 beaten the portfolio.

There are several keys to building this type of portfolio.

We don’t want to be captive to what is happening in the major stock indexes, so we want most of the funds to have a low correlation to the S&P 500. The portfolio as a whole must have a low correlation to major stock indexes.

We want the portfolio to have fairly steady returns over time. That means some of the funds within the portfolio should have low correlations with each other. We expect that some will do poorly while others do well. Then, they will reverse roles.

Of course, we want the funds to meet our usual requirements of no loads, reasonable expenses, a search for value, and a margin of safety.

The laggard in the latest quarter was American Century International Bond. The dollar is doing well against foreign currencies, and that hurts this fund. Because of the recent dollar bear market, the fund registered solid returns over the last couple of years before reversing in 2005. Thanks to the balance and diversification of the overall portfolio, the fund’s negative return for the quarter did not keep the portfolio from registering a solid return.

Oakmark Equity & Income was our top performer in the last quarter, because its stock selections tend to be smaller companies. Lately, that is where the top returns in the stock market have been. The fund is closed to many new investors, though it still can be purchased directly from Oakmark. If you want to own the fund through a mutual fund broker, you won’t be able to purchase it. The best alternative is to double the allocation to FPA Crescent.

Berwyn Income is another balanced fund that soared in the quarter, though it largely was making up ground lost in the first quarter. It benefited from smaller company stocks and a heavy allocation to energy industries.

The rest of the funds had very similar returns for the quarter despite having very different investment disciplines. Longer-term, their returns have greater differences.

Third Avenue Value remains open to new investors, though the International Value and Real Estate funds from Third Avenue recently closed. Given its strong recent returns and its past history of closing, the probability is that Third Avenue Value will close in coming months. It will be difficult to find a substitute for this unique fund. Anyone interested in setting up an Alternatives Portfolio should do so soon.

Price High Yield also is closed to new investors. The best alternative here is Neuberger & Berman High Income fund.

This is a long-term, set-it-and-forget-it portfolio. We recognize that each fund has its up and down cycles. But the majority of the funds should not be experiencing an extended down cycle at the same time. They balance each other and together produce fairly steady, solid long-term returns. That is how the portfolio is able to achieve higher long-term returns than the S&P 500 with less volatility and with a low correlation to the stock index.