Hedging Strategies
I have been a firm believer in alternative investing and recent advancements in the products available to the masses have allowed access to once untouchable strategies. Our friends at Rydex Investments have update their returns for the Essential Frontier (TM) portfolio through 2008 to compare to the basic Efficient Frontier portfolio.
The main difference is that the Rydex Essential (TM) portfolio contains a 20% allocation to alternative strategies: 4% NAREIT Index, 4% S&P GSCI, 4% Tremont Hedge Fund Index, 4% Tremont Long/Short Index and 4% S&P Diversified Trends Indicator/Managed Futures. As stated many of these strategies are now available via open-ended mutual funds or exchange trades funds. Now for the proof.
Over the previous 10 years (ending in 2008) the Rydex Essential (TM) portfolio rose 4.79% compared to a rise of 3.77% for the basic Efficient Frontier portfolio. The average standard deviation (a common measure of risk) over this same 10 year time period for the Rydex Essentials (TM) portfolio was 8.73% compared to 10.06% for the basic Efficient Frontier portfolio. The inclusion of a 20% allocation to the traditional portfolio of cash and bonds led to a +27.02% difference in returns, while reducing risk by 13.21%.
On the heels of one of the worst annual performances in 2008, the stock market was not the only asset class to suffer historic losses. While many investors focus just on individual stocks, the deleveraging of hedge funds and forced selling that caused the cascading crash in the fall of 2008 has created potentially greater opportunities in other areas of the market. The folks at Absolute Advisors have outlined this in greater detail. They analyzed returns of various asset classes going back to 1990.
While the S&P 500 was -38.5% in 2008 it was the worst annual loss since the -22.10% drubbing in 2002 over this time period. The loss suffered last year was 1.7% greater than the worst previous loss since 1990.
The HFRI Equity Hedged Index was -26.16% last year compared to the worst annual loss of -4.71% in 2002 over this time period. The loss suffered last year was 5.6 times greater than the worst previous loss since 1990.
The HFRI Distressed/Restructuring Index was -24.94% last year compared to the worst annual loss of -4.23% in 1998 over this time period. The loss suffered last year was 5.9 times greater than the worst previous loss since 1990.
Finally, the HFRI Convertible Arbitrage Index was -34.67% last year compared to the worst annual loss of -3.73% in 1994 over this time period. The loss suffered last year was 9.3 times great than the worst previous loss since 1990.
As you can see in these examples, one of the reasons why alternative investing is attractive even after the stock market rout is that the magnitude of potential opportunities potentially far exceeds that of stocks.
We wanted to discuss one of the questions we hear the most now: what is the opportunity cost of adding alternatives at this point to my portfolio only to see the stock market rally? Since this is a FAQ (frequently asked question) I again turned to the folks at Absolute Advisors to review past market turns in order to compare performances.
What they found was very interesting and helps to continue to make the case for adding alternatives at any point in time to your portfolio. They created an alternative index split equally into the HFRI Equity Hedge Index, HFRI Distressed Index & HFRI Convertible Arbitrage Index. The first study was after the Savings & Loan Crisis of the late 1980's. In the last year of this crisis (1990) the Alternatives Strategies returned 7.68%, while the S&P 500 was -3.10%. Then they reviewed the following three years all of which were positive for the broad equity markets. Over the 1991 to 1993 time period, the Alternative Strategies returned 25.71% annually, while the S&P 500 returned 15.62% annually.
The next observation was after the Technology Bubble of the late 1990's. During the last year of this bubble (2000) the Alternative Strategies returned 3.21%, while the S&P was -22.10%. Over the subsequent three years (2003 to 2005), the Alternative Strategies returned 11.48%, while the S&P 500 returned 14.39%.
As you can see the alternative strategies outperformed in the last year of the crisis in both cases and then captured 164% of the upside in the first observation and then captured 80% of the upside in the second observation.
