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With the recent market downturn and increased volatility, many investors are finding that funds like long/short funds, that were counted on for diversification during downturns are not providing the protection desired. Stock-Net reports on some findings regarding relative performance of long-short mutual funds during the recent market drop.

Long-Short mutual funds are touted to provide less volatility and more steady gains by using offsetting long and short portfolio positions. In the case of an even long / short offset, a market-neutral status can happen, meaning that the fund returns should be strictly based on manager skill and would be independent of market direction.

In reality, the recent performance of long/short funds has been very poor. This has not been isolated to a few long/short funds, as the entire category has been disappointing. In the month ended August 3rd, the long / short category was down 5.3%, compared to a decline of 5.9% for the S&P500.

It is not a good idea to make decisions about a fund based on a short period of performance, but this period has been a critical one that could call into question the assumption that long/short funds offer downside protection to your portfolio.

For some detailed views on this, please compare the performance of a sample of long/short mutual funds against the S&P500. The funds highlighted include: JPMorgan Intrepid Long Short, Old Mutual Analytic US Long Short, Laudus Rosenberg Value Long/Short, and Robeco Boston Partners Long / Short Equity.

Are there other options for investors that wish to invest with a very diversified portfolio and reduce the exposure to market downturns? One option is to utilize some of the new privately constructed ETF portfolios offered by some leading analytical and quantitative investment houses. An example is the Caprock Analytics Conservative ETF portfolio, available to subscribers of Caprock Analytics. In the past month, the Caprock Analytics Conservative Portfolio has posted a gain of 0.2%, as compared to the decline in the S&P500 of 3.5%. Over the past year, the Caprock Analytics Conservative Portfolio has delivered a return of 14.3%.

As I posted in an earlier article on Stock-Net, Alpine Dynamic Dividend Fund has posted some very impressive yields of around 13% recently. Based on these very attractive yields, a reader has asked “Can I live off Alpine Dynamic Dividend income?”. Apparently, as this perceptive reader has pondered, are these yields reliable enough to increase the level of income from your investments, perhaps to the point of supplementing or supporting your lifestyle?

Bonds vs. Alpine Dynamic Dividend

I will analyze this topic from a couple of different angles. First, lets compare the yield from Alpine Dynamic Dividend to what you may expect from another income source. For example, a typical retirement portfolio may have an allocation of bonds, providing a steady level of income with low variability of principal. With current bond yields, you may expect to receive about 4% – 6% yields. Short term bonds provide good principal protection, but relatively lower yields, while longer term bonds offer some higher yields with the possibility of principal loss if interest rates rise. A disadvantage of bonds are that they offer little in the way of inflation protection, as historically, bond yields have roughly tracked or slightly lagged inflation rates.

So, lets do a high level comparison of Alpine Dynamic Dividend with long term bonds:

• Inflation protection: Long term bonds – minor, Alpine Dynamic Dividend – good
• Yield – Long term bonds – 5-6%, Alpine Dynamic Dividend – 12 – 13%
• Principal Stability – Long term bonds, good to moderate, Alpine Dynamic Dividend – moderate to low stability
• Income Stability – Long Term Bonds – stable, Alpine Dynamic Dividend – moderate stability

Annuities vs. Alpine Dynamic Dividend
Another income choice for a retirement portfolio is an annuity. A typical annuity is purchased and provides a fixed monthly income for the remainder of your life. As an example, a 65 year old man investing $100,000 can expect to receive about $690 per month for life, totaling about 8.3% of your original investment amount each year. You can check some other annuity options at ImmediateAnnuities.com. While this may sound good, and provides a higher income than bonds, your principal is gone once you purchase the typical annuity, and you will only receive the specified income stream for life. Once you die, there is no principal from the annuity remaining in your estate.
Let’s make a comparison of Annuities vs. Alpine Dynamic Dividend:

• Inflation protection: Annuities – typically none, Alpine Dynamic Dividend – good
• Yield – Annuities – 7-8%, Alpine Dynamic Dividend – 12 – 13%
• Principal Stability – Annuities, none (principal is gone), Alpine Dynamic Dividend – moderate to low stability
• Income Stability – Annuities – guaranteed, Alpine Dynamic Dividend – moderate stability

Bottom Line: Alpine Dynamic Dividend may be a good way to supplement your other income sources.

Build your own annuity?

Consider this option: Invest a portion of your portfolio, that may have otherwise been targeted for an annuity, in Alpine Dynamic Dividend Fund. If your annuity would have paid 7% annually, then take 7% annually from the Alpine Dynamic Dividend income stream, and reinvest the remaining income back into the fund. As yields may vary over time from the fund, you can vary the level of reinvestment to smooth out your extracted income stream. This reinvestment could also help provide a buffer against inflation over time by growing the amount invested in the fund. Plus, consider this, you still have your original investment amount in Alpine Dynamic Dividend, whereas you would have given up the investment amount when purchasing an annuity. Offsetting these advantages of investing in Alpine Dynamic Dividend, you would have to expect to handle more volatility in the income and account value, as the market fluctuates. Considering these advantages, Alpine Dynamic Dividend seems to be a viable option for some portion of your income portfolio.

In the world of mutual funds, investors typically face a choice between Index or actively managed funds. But now, as Stock-Net reports, there is now an alternative: enhanced index funds. Fidelity is now offering three enhanced index funds that promise to combine the advantages of indexing and active management.

Fidelity’s new funds include: Fidelity large cap core enhanced index fund, FLCEX, Fidelity large cap growth enhanced index fund, FLGEX, and Fidelity large cap value enhanced index fund, FLVEX. The core fund is designed to track the S&P500, while the growth and value funds track the Russell 1000 Growth and Russell 1000 Value Indexes, respectively. Each fund has an expense ratio of 0.45% annually.

How are these funds enhanced? According to Fidelity, they plan to start with a list of stocks that track their target index, then use advanced computer models to rank stocks in each index. From the rankings, they plan to adjust fund holdings to target enhanced performance. Fidelity expects these funds to out-pace the performance of indexes over time, with the trade-off of moderately increased volatility.

Since these funds are new, it will bear watching to see how these funds perform over time. Since you can buy some index funds with expense ratios of less than 0.10%, these enhanced funds will need to beat their index at least 0.35% annually just to break-even after expenses. If they can deliver, these funds could enhance your portfolio’s returns.

Stock-Net reviews some mutual funds that stand out from the pack due to their strategies. These funds emulate the hedging techniques of hedge-funds to reduce volatility and seek to provide more absolute returns.

Hedge funds have increased in popularity in recent years, as more institutions and wealthy individual investors have increased their hedge fund investments. Much of this is due to the good relative performance of hedge funds during the market downturn of 2000-2002.

For individual investors, hedge-fund-like investments can serve as a powerful diversification instrument, and many financial planners advise holding up to 20% of your portfolio in this investment type. The main problem has been the high entry hurdle for individual investors to invest in hedge funds, since most hedge-funds require that investors be ‘accredited’, meanly that only the very wealthy investors will qualify. However, with the advent of mutual funds with hedge-fund characteristics, access to hedge-fund strategies are now much more readily available to the average investor.

Some hedged mutual funds use a ‘long/short’ strategy, where part of their portfolios are invested long and part of the portfolio are short. If constructed properly, these portfolios can provide a consistent return with limited downside risk, reduced volatility, and reduced correlation with market movements. For example, Schwab Hedge Equity fund, SWHIX, uses computer-based analysis for long/short portfolio selection, can vary the net bias of the fund based on market conditions. Currently, the fund is net long. Since its inception, the fund has provided returns that match the S&P500, but with about 40% less volatility.

A similar approach is in place at the Hussman Strategic Growth fund, HSGFX. This fund can hedge some or all of its portfolio, depending on market conditions. The Hussman Strategic Growth Fund utilizes S&P500 and Russell 2000 options to hedge the portfolio, as needed. This fund performed very well during the 2000 to 2002 market downturn, delivering double-digit gains while the broad market suffered major losses. Recently, this fund is back to a full hedged condition, as the manager believes stocks are again fully valued.

Other funds employ different strategies. For example, the Gateway fund, GATEX, aims to deliver market returns with reduced volatility. In general, it owns stocks that track the S&P500, and employs options to provide enhanced income and hedging, typically by selling call options. These fund has delivered around 7% annualized over the past 10 years, with about half the volatility of the S&P 500.

Another fund, the Laudus Rosenberg Value Long/Short Equity fund, BRMIX, splits its portfolio 50% long and 50% short. This ‘market-neutral’ approach has the advantage of providing returns uncorrelated with the market, but can be the long-term returns can be erratic. During the 2000-2002 bear market, the fund produced a total gain of 65%, but the fund lost money during 1998 and 1999, strong years for stocks.

Yet another unique fund in this area is the Merger Fund, MERFX. This fund utilizes a strategy of merger arbitrage to provide steady returns investing in securities involved in mergers and acquisitions. This fund has low volatility, low market correlation, and has provided near market returns over the past several years.

Consider these funds as you look to diversify your portfolio. A graph of these funds recent performance is provided for your reference. Note that several securities in the following graph have made large dividend and/or capital gains distributions, resulting in large, short term drops in NAV. Your total return while holding these funds would be correspondingly larger than the graph reflects.

Many investors will only consider mutual funds once they have a lengthy investment track record, but ignoring all new mutual funds may not be the best choice. Stock-Net has identified some new mutual funds, run by experienced managers, that you should consider.

Many older, larger mutual funds begin to perform poorly, as their size restricts their ability to easily invest in some smaller, more thinly traded securities. As fund size grows, trading costs can increase since trading a sizable position in a moderate or low volume security can affect the security price, increasing the cost of adjusting a position in a stock.

Newer, smaller funds can be more nimble, and a good manager can take advantage of this and produce better returns. Here are a sample of some newer funds to investigate: Vanguard FTSE All-World Ex-US fund, continues the Vanguard tradition with a low expense ratio of 0.40%, and provides access to a range of international stocks.

Thornburg Global Opportunity A, THOAX, offers a concentrated approach to midcap investing, with a 1.63% expense ratio. Ranier MidCap Equity, a sister fund to another, closed, Ranier fund, offers a proven midcap investing approach with 1.35% expense ratio.

Harbor Global Value fund, HIGVX, with a 1.38% expense ratio, invests with a value approach, and has the flexibility to allocate among both international and US stocks. Artisan Opportunistic Value fund, ARTLX, offers another midcap investing approach, with a 1.49% expense ratio. Finally, the Domini PacAsia Social Equity fund, DPAFX, applies a social and environmentally screened investing approach to Asia pacific stocks, and has a1.60% expense ratio.

Consider these funds as you add to your existing investment portfolio.