Few Alternative Funds Make Cut

Many funds aim to hedge against risk while offering upside potential. But should you trust your money with any of them?

Paul Jacobs, a certified financial planner with wealth-advisory firm Palisades Hudson Financial Group’s Atlanta office, wanted another way to reduce portfolio volatility besides bonds. So he screened more than 600 mutual funds and exchange-traded funds (ETF) that use various hedging strategies and came to the conclusion that all but very short-term bonds are too risky today. Those other bonds will plummet when today’s ultralow rates rise sooner or later.

Jacobs required at least three years of results — preferably four years to include 2008, the ultimate stress test. That cut down the field by more than half.

High management expenses, up to 4% annually, ruled out many others. Jacobs also eliminated all funds with a “black-box” strategy — like the one that fell 15% last summer when it made bad bets, like shorting the Swiss franc.

He got rid of funds that short large-cap U.S. stocks because the market is very efficient there. He also tossed out funds that depend on an investment “rock star” because a star manager may leave or suddenly become less brilliant during a downtown than he initially seemed.

Some funds didn’t make the grade because they had poor returns. Several alternative funds — including offerings from Vanguard and J.P. Morgan — even managed the difficult feat of losing money in both 2009 and 2010.

Ultimately, Jacobs narrowed the field to several promising candidates. Palisades Hudson’s investment committee, which he sits on, reviewed them, and then voted all but one off the island.

They chose Merger Fund (MERFX), which has racked up positive returns in all but two of the last 15 years. It declined only in 2008 (a mere 2%) and in 2002 (6%) and has shown very low volatility — a miniscule beta of 0.09.

Merger Fund uses a merger-arbitrage strategy. It buys the stocks of acquisition targets and sometimes shorts the acquirer’s stock. When deals close, the fund makes money. To prevent losses when deals fail, it hedges risk by using put options and other derivatives.

Palisades Hudson replaced 5% to 10% of its clients’ fixed-income portfolios with Merger Fund. It also added JPMorgan Tax Aware Real Return Fund, a muni bond fund that aims to protect against inflation by buying inflation swaps with a portion of the income.

To do that, it recently sold its clients’ holdings in Treasury Income-Protected Securities (TIPS). Ten-year TIPS had a great 2011, gaining 15.72%. TIPS tend to trade like conventional Treasuries when interest rates are falling, and Jacobs and his colleagues believed it was time to reap the profits.

“With interest rates still near all-time lows, simply holding bonds may not be the best way to lower your portfolio's volatility,” Jacobs says. “Replacing some of your bonds with a low-risk hedge fund strategy, in the form of a transparent a mutual fund with a solid record, may be a smart move.”

Look at your total portfolio and understand how any new fund or ETF would fit in before investing, he adds.