Warren Buffett bet $1 million that the Vanguard S&P 500 index fund will outperform five funds of hedge funds (averaged returns, net of fees) picked by professional money management firm Protégé Partners LLC, Fortune reported this week. Though the winner will not be determined until the end of 2017, if Protégé wins, there might be—at last—one more solid argument against the efficient market theory. (Even Buffett thinks his chances of winning are only 60 percent, says Fortune.)
The bet got us wondering: What the heck is Buffett thinking? Is this the next stage of the "Dartboard Contest"—the now defunct column in the Wall Street Journal that pitted professional stock pickers against randomly chosen stocks chosen by throwing a dart at the stock tables? Buffett's wager isn't one we'd take, since the consensus is that we're in a low-return cycle for traditional stocks and bonds—well, for the near future, anyway.
And that got us thinking further: The equity market looks downright horrible for the near term, with vicious volatility on top. What to do about that? You can't just go long the S&P 500 and expect your clients to appreciate your wonderful advice. (They'll continue to flee to money market funds.) So, what strategies are financial advisors adopting to eke out higher returns for their clients? They are using one of the many hedge-fund-like, absolute-return strategies that are now available in regular, open-end mutual funds.
"We thought it was a good idea to look beyond those traditional asset classes, and look at investments that can deliver good equity-like returns with a lot less volatility over a market cycle," says William Harding, director of research at Morningstar Investment Services, a turnkey, discretionary investment management program that manages $2.2 billion for financial advisors.
Three years ago, Harding says, he and his colleagues decided the fixed income markets weren't going to present compelling return opportunities for the next several years. So in April 2005, Morningstar launched an absolute-return portfolio, which has become one of the main strategies for advisors to get some return—any return—in up markets, and to lose little—or none—in down markets. It depends on the client, but, Harding says, most allocate 5 percent to 10 percent of the assets in the portfolios to absolute-return strategies. In some rate cases, Harding has customized a portfolio to allocate 25 percent to the strategy.
Given the recent turmoil in the capital markets, it's no wonder the absolute-return approach has gotten so popular: Morningstar follows 179 funds in the long/short category (including multiple share classes), accounting for $24.9 billion in assets as of the end of May. And Harding says that figure has about doubled over the last three years.
Many of these funds were introduced over the last two or three years. The biggest and most established (its current strategy it was launched in 1988) is the Gateway Fund, at about $4.7 billion. Clearly, the hedged strategy has earned market acceptance since 1988. The Absolute Strategies Fund, born in July of 2005, already has over $1 billion in assets-despite not having a three-year track record. Some other growing funds are Diamond Hill Long-Short at $2.6 billion, Hussman Strategic Growth fund with over $3 billion and Calamos Market Neutral fund with about $1.6 billion. Harding says there are also other funds that have over a billion in assets, including the JP Morgan Multi-Cap Market Neutral fund and the Janus Advisor Long-Short fund.
Back in the early 1990s, the big endowments—such as Harvard and Yale—began to decrease their exposure to domestic stocks, instead allocating more to less-liquid and alternative assets, including absolute-return strategies. Since then, Harding says, those institutional strategies have trickled down to retail advisors and individual investors. "I think investors and financial advisors have been more open to looking beyond the mainstream run-of-the-mill strategies, searching for investments that could enhance the diversification of the portfolio, and hopefully smooth out returns and deliver good absolute-type returns," says Harding.
Indeed, the financial services community learned that trying to beat an index without regard to risk is a dangerous game. "A lot of the things that are working for us right now aren't really market or index related," says Timothy Holtzman, one of three core advisors who make up the Pittsburgh-based Legend Financial Advisors, an RIA managing around $350 million for about 200 high-net-worth clients. Legend is beating the index, Holtzman says. While the S&P dropped 11 percent between October 9 and early this week, Holtzman says one of their core portfolios is up about 5.5 percent by using a combination of structured notes, merger-and-arbitrage funds, funds that bet on the currency, country specific ETFs and commodity index ETFs, such as the Dow Jones AIG-Commodity Index fund.