It's an old dilemma. In a recession, as we're in now, you want to load your portfolio with money-market funds and high-quality bonds that afford some defense against falling stock prices. But if you invest too heavily in these assets, you run the risk of not achieving your financial goals, especially because bond yields are so low. If inflation came back, those bonds would be toxic.
Don't give up entirely on bonds and money funds as risk-reduction tools. But you should also consider specialized mutual funds that can help reduce portfolio risk while improving long-term returns. Some invest in mergers, while others ride the commodities markets, trade stock options, or even sell stocks short.
You might, for instance, shift some money into the Merger Fund or Arbitrage Fund (BW--Dec. 17). These funds play the mergers-and-acquisitions game, buying stock of the target company and selling short the buyer. Their returns depend not on earnings reports or new products but solely on whether announced deals are completed. The Merger Fund, the oldest arb fund, has delivered a 10.8% annualized return over the past 10 years, besting the average bond fund's 7.0% return with a comparable level of volatility.
Another approach is to invest in a vehicle such as Gateway Fund, which employs a "covered call" strategy. The fund sells call options on the stocks in the Standard & Poor's 500-stock index, giving buyers the right to purchase its stocks if they rise to a predetermined price by a specified date. In return, Gateway collects a call premium, which produces an 18% to 20% annualized income flow for the fund. Then, the fund uses some of that income to buy put options, gaining some downside protection. The results have been a 9.1% annualized return over 15 years with low volatility. Also, since option premiums go up when interest rates rise, the fund moves in the opposite direction from bonds, making it a good portfolio diversifier.
Then there's the "long-short" fund, which, in theory, at least, can make money in any kind of market. Like most mutual funds, it owns stocks--that's the "long" part. But unlike most funds, these vehicles can sell stocks short. That allows them to prosper as prices tumble. Boston Partners Long-Short Equity Fund has delivered a 21.6% return this year because manager Edmund D. Kellogg shorts stocks with high price-to-book values and weak balance sheets and buys those with low p-b's and strong financials. The smart strategy is to use these funds to balance out your other equity holdings. So if you own a growth-stock portfolio, throw in a 10% position in a value-oriented long-short fund. Or buy one that emphasizes growth, such as Needham Growth Fund, if your portfolio has a value tilt.
Although we're in a recession, the rate cuts, if they take hold, could spark inflation--and neither stocks nor bonds will protect against this risk. Rapidly rising producer prices can put a squeeze on corporate profit margins, causing stocks to decline. At the same time, inflation makes the yields on income-producing investments less attractive. If, say, the inflation rate rises to 6%, and your bonds are yielding 5%, then you are actually losing money on an inflation-adjusted basis.
Three kinds of instruments can help immunize your portfolio against inflation to varying degrees: Treasury Inflation-Indexed Securities (TIIS), commodity futures, and floating-rate loans.
TIIS, which are debt securities issued by the federal government, have the most direct correlation with inflation. In TIIS, the principal rises with increases in the consumer price index (CPI), which tracks prices on goods and services such as food and energy. In addition, TIIS pay out bond income, ensuring your investment outpaces inflation. "Almost all other asset classes--if inflation goes up, they go down," says Peng Chen, research director at Ibbotson Associates.
For this reason, Chen recommends that investors have at least 5% of their portfolio in a TIIS mutual fund. That percentage, he says, should increase in proportion to your dependency on investment income to pay for inflation-sensitive goods such as food and health care. So if you're retired, TIIS could be the majority of your fixed-income portfolio. One caveat: Owning TIIS outright instead of through a fund probably does not pay, because the securities' inflation adjustment is taxable, even though you don't get paid until the bonds mature. TIIS mutual funds, however, do distribute the adjustment to shareholders as regular income.
For long-term investors, a 5% or 10% position in Oppenheimer Real Asset Fund is also a good inflation hedge. By owning a combination of commodity-linked bonds and futures, the fund tracks the Goldman Sachs Commodity Total Return Index, a composite of energy, agriculture, and metals futures prices. Over the past 30 years, this index has delivered a 12% annualized return, compared with 12.8% for stocks. Although volatile by itself, the fund will reduce a portfolio's overall risk, because it performs best when stocks and bonds are down. Indeed, when equities fell 40% in the 1973-74 bear market, commodities were up more than 120%.
Floating-rate loan funds are less volatile than commodities, but not as safe as TIIS. These funds invest in senior secured bank loans, which are of junk-bond credit quality. Since these loans reset their rates every 40 days or so, they avoid much of the volatility of the bond market. That means if the Federal Reserve raises rates to stifle inflation, these funds won't lose money like a typical bond fund. But interest rates and inflation don't move in lockstep. Indeed, in 2001 the Fed cut rates much faster than the inflation rate fell. So the yields on these funds suffered.
None of these alternatives should replace the pillars of an investment portfolio: stocks, bonds, and cash. But shifting some cash into a TIIS fund and some bonds into an arbitrage or covered-call fund should reduce risk and improve returns over time. Adding a long-short or commodities fund on the margins might give you the extra kick you need to stay ahead of the crowd. By Lewis Braham