With the economic recovery recently turning bumpy, investors have grown wary of downside risk in their investment portfolios and are increasingly willing to give up some returns in exchange for protection from those risks. Volatility spiked in May, as concerns about European sovereign debt and a bigger-than-anticipated slowdown in China's economy shook the market's confidence.
More than nine months into an economic recovery, you would expect investors to be reaching for high returns, but that's not the case, says Jeff Cusack, president of Forward Funds, who's seeing much greater interest in risk control. The traditional approach to modern portfolio theory, which focuses on diversified asset allocation and portfolio manager selection, is being challenged as never before, he says.
"Financial advisors are saying: 'We need to be more tactical and nimble'" because their clients are telling them they can't handle anything akin to the losses they suffered in 2008, Cusack says. He believes the missing piece in most portfolio management is what he calls exposure management. "Sometimes you should be out of the way—not fully invested and watching the value of your assets go away."
While hedge funds lost much of their luster in the fall of 2008, when they proved not to be as insulated from high correlation among asset classes as most people had been led to believe, financial advisors and retail investors are entrusting more money to mutual funds with hedge fund-like characteristics. Tactical allocation portfolios generally comprise a core strategy—broad exposure to traditional asset classes such as developed market stocks and government and corporate bonds—and a satellite strategy. The latter typically holds international small-cap stocks, emerging market stocks, and debt, along with U.S. and non-U.S. real estate via Real Estate Investment Trusts, or REITs. Since some of these portfolios use index-tracking exchange-traded funds, the high fees for active management could irk some cost-conscious investors.
Tactical allocation portfolios aim to make money for investors in both up and down markets. A key way to achieve this is by minimizing volatility in the portfolio. The Goldman Sachs Absolute Return Tracker Fund (GARTX), which tries to replicate the returns generated by a broad assortment of hedge funds, had a two-year volatility of 7 percent as of May 31, 2010, far less than the 24 percent for the Standard & Poor's 500-stock index, and 36 percent for the Goldman Sachs Commodities index, over the same period. In May 2010, the fund was down 2.43 percent, vs. an 8 percent loss for the S&P 500 and a loss of 11.3 percent for international stocks, says Theodore Enders, portfolio strategist for Goldman Sachs Asset Management's Portfolio Strategy Group.
The portfolio currently has positions, through futures contracts, that track the S&P 500 index, TOPIX (the Japanese large-cap index), the United Kingdom's FTSE-100 index, and the Eurostoxx index, along with a position that inversely tracks the Russell 2000 index—a bet against U.S. small-cap stocks. The fund has holdings in the iShares MSCI Emerging Markets index (EEM) and uses futures contracts to bet against the U.S. 10-year Treasury Index. It also has futures contract positions that track the S&P 500 Commodities index and its precious metals sub-index, and allocates some money to cash, largely through money market funds. The portfolio avoids single-security positions such as industry pair trades, merger-arbitrage deals, and individual stocks.
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