This piece originally appeared on Forbes.com.
Recovery or bubble? Stock and housing prices are rising, but the real economy refuses to play along. The Fed’s history-making liquidity gambit may have induced a impressive revival … or a false spring that merely delays the true reckoning for decades of too much debt.
Which is it? I don’t know… and if you do, you shouldn’t be wasting your time with this column. What I do know is that, amid such powerful cross-currents and wildly divergent potential outcomes, making big one-way investment bets looks like a darn dangerous gamble.
What, then, to do? These days, it’s become a lot easier to do what the truly elite money managers have done for decades: have it both ways by using alternative investments. The idea is twofold: using classic hedged approaches to the financial markets; and diversifying into “uncorrelated” asset classes that zig when traditional markets zag. Let’s see how these ideas work.
Surprisingly, it was the legendary value investor Benjamin Graham, Warren Buffet’s hero, who invented the first hedge fund. Back in the Roaring Twenties, he realized that he could make money regardless of the overall direction of the market with what has become the signature hedge fund strategy, a “long short” trade.
Once you know the trick, it’s an obvious idea. Let’s say you’re convinced that Royal Residences is the best homebuilder out there; and Sinkhole Sandlots is the worst. If you buy Royal and sell short an equal amount of Sinkhole, you’ll profit regardless of overall market direction– provided that Royal performs relatively better than Sinkhole. If the market goes up, Royal should increase more than Sinkhole, meaning you’ll make more on your long than you’ll lose on your short; in a market slide, Royal will go down less than Sinkhole, so you’ll make more on your short than you’ll lose on your long.
Such trades– which can work in and across innumerable asset classes –are at the heart of thousands of hedge funds. Most don’t exactly even out their long and short bets, so they are indeed taking an overall view of the market (most have what’s called a “long bias”). Nonetheless, they are hedging their stock market exposure, trying to make money while limiting the risk of losses.
To me, that sort of approach makes a lot of sense right now. And the interesting news is that numerous mutual funds now pursue it. Some even go further, spreading their bets around through other mutual funds that run long/short strategies… a mutual fund of mutual funds, all running a reduced-risk approach. That provides excellent diversification, and if you select one with low total fees, can make a lot of sense.
So that’s one example of the kinds of loss-limiting strategies that savvy investors favor; we’ll talk a lot more about others in future columns (impatient? pick up my book, The Alternative Answer). Meantime… what was that about investments that actually zig when the markets zag? That, after all, is the holy grail of diversification.
First, let’s remember that a lot of folks were nastily surprised back in 2008 by the way their investments all swooned together. The “nine buckets” of stocks all emptied at once, just home prices fell out of bed, too. Turns out, it’s not so easy to find options that really do perform differently in a true economic crisis. But some do exist.
For example, many “global macro” and “managed futures” funds did very well in the crash. These types of managers use super liquid futures contracts to play everything from soy beans to natural gas, and from copper to sovereign debt. They tend to excel when governmental policies and behavioral economics trump classic fundamental analysis– that is, amid crises. Other managers profited by sticking to markets, like electricity trading, that were impervious to the stock market moves. Income-producing real assets, like timber and infrastructure, also survived largely unscathed … so long as you weren’t forced to sell because of debt service requirements.
As you can see, this is a broad and deep subject, and we’ll explore all these topics in much more depth in the coming months.