3 Funds That Swim Against the Tide

08/13/2014 10:00 am EST

Focus: FUNDS

Carolyn Bigda of Kiplinger’s Personal Finance looks at a trio of funds that employ alternative strategies; she suggests that adding these funds to a balanced portfolio can help reduce the overall risk from a broad market downturn.

Steven Halpern:  Joining us today is Carolyn Bigda of Kiplinger’s Personal Finance magazine.  How are you doing today, Carolyn?

Carolyn Bigda:  I’m great.  Thanks.

Steven Halpern:  Thank you for joining us.  In the new issue of Kiplinger’s that just hit the newsstands, you focus on funds that use alternative investment strategies to do what you consider “swimming against the tide.”  Could you help explain what you mean by alternative strategies?

Carolyn Bigda:  Sure.  It can be a bit of a broad category when you talk about alternatives.  It can mean lots of different things.  In our case, we were talking about strategies themselves, so, not necessarily just alternative investments like commodities or REITs or that kind of thing. 

These are the strategies that investment managers are using.  Some of them might be—instead of just buying a stock and hoping that it goes up in value over time—a manager might do what’s called shorting a stock and sort of making a bet that the stock is going to fall in price and try to profit from that. 

These are strategies that essentially don’t move in tandem with the broader market and, as a result, you sort of generate different returns that help diversify a portfolio.

Steven Halpern:  There’s historical support for this overall thesis that these types of funds add value to a portfolio.  Could you expand on that?

Carolyn Bigda:  Yeah, the value really comes over the long-term.  One investment firm, Robert W. Baird, they did a calculation where they found that for the 20 years through the end of September of 2013, your traditional 60/40 portfolio of stocks and bonds returned an annualized 7.9%, so almost 8% a year.

If you diversify that into like, 50% stocks, 30% bonds, and you put 20% into some of these alternative strategies, you increase that annual return by a little bit.  It actually was an 8.2% annualized return, and also, the portfolio itself experienced less volatility. 

By incorporating some of these into a portfolio you could potentially improve the risk adjusted return, but it’s over a long period of time.

Steven Halpern:  You also emphasize in your article that adding alternatives to a portfolio is not without risk, so what do investors need to be concerned with?

Carolyn Bigda:  Sure.  A lot of mutual funds have been coming out recently using alternative strategies and it’s, sort of, a growing category.  When you are looking at these funds they are cheaper than hedge funds, which traditionally are alternative strategies.  They’re more liquid and you can sell your assets in these funds on a daily basis. 

Those are all good things, but—because these funds are pretty new—a lot of them don’t have a long track record to go on, so you just want to be mindful of that.  Not all these funds have been around for different market cycles. 

Possibly, you want to look for funds that do have a longer track record, and you also want to keep in mind that some of these strategies are a little costly to execute, and so these funds will have higher fees and, over time, is going to eat into returns as well. 

You just want to make sure that you are not paying through the nose for these strategies and it’s actually going to be beneficial to your portfolio, not too costly.

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Steven Halpern:  One fund that you highlight that follows an alternative strategy is the Merger Fund (MERFX).  Could you tell us about this?

Carolyn Bigda:  Sure.  The Merger Fund has been around for a long time, about 25 years.  It’s a member of, what we call, the Kiplinger 25, so we like the fund a lot.  Basically, its strategy is best in stocks of already announced takeover and merger targets. 

By doing that, it’s hoping to get, sort of, the last bit of appreciation in the stock before the deal is finalized.  In a bull market like today it’s not going to perform as well, but it will, sort of, give you that incremental return over time and it’s really going to hold up well in a broader market downturn. 

In 2008, when the S&P was following close to 40%, this fund lost just a little over 2%, so it’s really there to help smooth out returns.

Steven Halpern:  A slightly riskier bet that you highlight is the Wasatch Long/Short Fund (FMLSX).  What’s the story here?

Carolyn Bigda:  This fund is trying to provide stock-like returns but with fewer bumps in the road.  A percentage of the fund is going to be invested long, meaning it’s going to be invested in stocks hoping that the stocks will rise in the value. 

Another percentage is going to be invested in shorts.  It’s going to be betting that certain stocks will fall in value.  The idea again is that you get some of the upside of the market, but you minimize the downside as well.  It does this pretty well. 

Like in 2008—again, when the S&P 500 was following close to 40%—this fund only dropped about 21%.  Again, it’s not going to be a completely safe bet, but you are definitely going to be minimizing some of the downside.

Steven Halpern:  Finally, another alternative strategy is called market neutral and in this area you highlight the TFS Market Neutral Fund (TFSMX).  Could you explain this fund for our listeners?

Carolyn Bigda:  Sure.  It’s a fund that’s been around for about a decade.  It was closed to new investors in 2009, but has recently reopened.  It takes a market neutral stance, which means it’s holding an equal ratio of both long and short positions in stocks. 

Again, this is almost primarily trying to smooth out the returns of the market and move in a different direction than stocks are going to.  Last year, for example, when the S&P 500 was up by more than 30%, this fund was just up a little over 1%. 

Again, in a bull market, it’s not going to perform as well, but when there’s a downturn it’s going to hold up better. In 2008 it lost just over 7%.  Again, it’s basically another way of smoothing out these market bumps in hopes of minimizing the downside in your portfolio.

Steven Halpern:  Again, none of these are the types of funds that somebody would put their entire portfolio in, but you’re suggesting that these are positions that somebody could consider in a broadly diversified portfolio.

Carolyn Bigda:  Exactly.  This is just a portion of your portfolio.  The core of it should always be diversified across stocks and bonds. 

Maybe you put 5%, 10%, even as much as 20% of your portfolio in one of these alternative strategies, like I had mentioned earlier, smooth out that return.  You’re right; it should not be the core part of your portfolio.

Steven Halpern:  We really you appreciate you taking the time to speak with us today.  Thank you.

Carolyn Bigda:  It was my pleasure.

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