Even after last year's rally, plenty of clients remain wounded, and, therefore, wary. As tempting as it might seem, most investors should not sit on the sidelines, not completely. With the economy stabilizing, analysts predict that S&P 500 company earnings will grow by 30.5 percent in 2010, according to ThomsonReuters. That should keep stocks and corporate bonds afloat.
To coax nervous investors into the markets, consider some of the quirky, risk-averse funds described below. Following unusual strategies, these choices can help to diversify portfolios.
One manager who stands out from the crowd is Tim Chapman of Stadion Managed Fund (ETFFX), which posted an average annual return of 1.9 percent over the three years ending January 6, outdoing 99 percent of its large blend peers, according to Morningstar. Chapman avoids big losses by relying on a stop-loss strategy. Whenever one of his holdings loses 5 percent or so, he sells it and shifts to cash. His caution insured that the fund only lost 5.8 percent in 2008, beating the S&P 500 by 31.2 percentage points for the year.
Most managers would sneer at Chapman's approach, saying that he is bound to miss the action when markets rally. Chapman cheerfully concedes that he will lag during bull markets. “If you avoid big losses in downturns, then you can do quite well in equities,” he says.
To decide whether to hold stocks, Chapman watches 15 indicators, including interest rates and the number of stocks hitting new highs and lows. When conditions seem healthy, he buys sector ETFs, holding the industries that have been showing the best upward momentum. Recently the portfolio included Technology Select Sector SPDR (XLK) and SPDR Gold Shares (GLD).
Spice Up Your Clients' Portfolios
Another steady choice is Westport (WPFRX), which ranks as one of the least risky stock funds. During the down years of the past decade — such as 2000 and 2008 — the fund outdid the S&P 500 by wide margins. Portfolio manager Ed Nicklin seeks otherwise strong companies that have fallen out of favor because of temporary problems. “We have no interest in shaky businesses with leveraged balance sheets,” says Nicklin.
A favorite holding is McCormick (MKC), the spice maker. Nicklin figures that sales will hold up reasonably well during hard economic times. When Nicklin can't find enough bargains, he holds cash. Most often the moves to cash have cushioned results. With problems appearing in 2008, the fund kept 22 percent of assets in cash.
Nicklin shops widely, holding stocks of all sizes, including growth and value names. The diversification has helped the fund excel in many different market environments.
Bond investors should consider Osterweis Strategic Income (OSTIX), a unique fund that can thrive during difficult market conditions. Hazards could appear this year if interest rates rise, as many analysts expect. When rates climb, bond prices fall, and many bond funds suffer.
To protect against interest-rate risk, Osterweis emphasizes short-term bonds. Those can be relatively resilient in the face of rising rates. Of course, many funds hold short-term bonds, but what sets Osterweis apart is that most of its short-term securities are rated junk. Few funds focus on this corner of the junk market.
Osterweis prefers junk issues because — obviously — they deliver high yields. While the short-term junk issues come with risk, they have relatively low default rates. This is so because bonds with one or two-year maturities have little time to go belly-up.
As the credit crisis unfolded in 2008, Osterweis turned defensive, emphasizing bonds with maturities of one year or less. The move helped to protect investors because short securities are relatively stable. For the year, Osterweis outpaced 95 percent of its multi-sector bond competitors.
As the economy improved in 2009, Osterweis turned a bit more aggressive. Portfolio manager Carl Kaufman began buying securities with three-year maturities. “We have been taking more risk as the credit markets have stabilized,” says Kaufman.
Along with bonds, investors have turned to hedge funds as a way to control risk. But hedge funds have a mixed record — as well as liquidity issues. During the past year, many funds blew up. For more stable results, consider IQ Alpha Hedge Strategy (IQHOX), which resembles an index fund.
Make no mistake, this is very different from typical index trackers. For a fund to track the S&P 500, the portfolio manager can simply buy all the stocks in the benchmark. But with 9,000 hedge funds, it is impossible to hold everything in the universe. To replicate the field, IQ Alpha studies publicly available data on hedge funds and develops a portfolio that should roughly track the group.
The fund holds long and short positions in ETFs. Recent holdings included PowerShares DB G10 Currency Harvest (DBV) and iShares MSCI Emerging Markets Index (EEM). “With 20 ETFs, we can cover all the asset classes that a typical hedge fund manager would use,” says Adam Patti, chief executive officer of IndexIQ, the fund's manager.
Why bother trying to track the overall hedge fund market? Because, if you find the right one or the right fund of funds, you can enjoy excellent returns. While individual funds may be expensive and risky, the universe overall has delivered intriguing results. During the 22 years ending in 2008, the average hedge fund returned 11.7 percent annually, outdoing the S&P 500 by 5 percentage points for the period, according to Hennessee Group.
IQ Alpha only began operating in the summer of 2008, but so far the fund has been performing as expected. IQ Alpha stayed in the black during the fourth quarter of 2008, a period when the S&P 500 dropped 21.9 percent.
For clients who are shy about venturing abroad, consider Federated International Leaders (FGFAX). During the past ten years, the fund has posted an average anual return of 8.6 percent, outdoing the Morgan Stanley Capital EAFE index by 6.6 percentage points and surpassing 97 percent of foreign large blend funds.
Portfolio manager Marc Halperin limits risk by favoring dividend-paying companies with high returns on equity. To pick up bargains, Halperin goes against the crowd, often buying stocks that others hate.
When bank stocks collapsed last year, he began buying financials. Currently he is snapping up hotels, including Accor (AC), a French company that owns Motel 6 and European luxury chains. With revenues languishing, hotel stocks have sunk. That has created bargains, says Halperin. “Business and leisure travel are way off, but we are starting to see some signs of recovery,” he says. “It's just a matter of time before the hotel stocks start to move.”