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Three Ways to Slash Your Risk ... And Still Make a Killing

Stock-Markets / Stock Markets 2011 Jun 30, 2011 - 07:50 AM GMT

By: Money_Morning

Stock-Markets

Best Financial Markets Analysis ArticleKeith Fitz-Gerald writes: With everything from the Greek debt crisis to worries about China's growth roiling the markets these days, the investing outlook seems to get shakier by the minute. And that means the same old tricks won't work any longer.

It's not going to be enough, for example, to simply pick stocks or spread your risk among large-cap, small-cap and a blend of domestic and international stocks and bonds thrown in for good measure.


Those things don't work when everything goes down at the same time - a painful reality that investors experienced during the financial crises of 2000-2003 and 2007-2009.

If we've all learned one thing from those crises, it's that stability matters when it comes to producing higher, more consistent returns - especially in a world in which the investing outlook is clouded by uncertainty.

But there are three strategies that can bolster your personal investing outlook and help you even out the rough sailing I see ahead.

Let me show you what I mean.

Three Strategies You Can't Ignore
The three strategies I'm talking about represent a break with the so-called "tried-and-true" approaches that were once in every investor's playbook, but don't seem to work so well in today's markets. So I'm recommending that you replace those old tactics with these three new ones, which will have you:

•Build your own "hedge fund."
•Adopt a "long/short" bond strategy.
•And consider a solid "alternative" to alternative investments.

Creating your own hedge fund is actually much simpler than you'd think. To illustrate, let's take a look at how a portfolio that was evenly apportioned in large caps, small caps, growth, value, domestic and international stocks (in other words, a portfolio allocation that's fairly standard fare among investors) would have performed from 2007 to 2009, a period in which the Standard & Poor's 500 Index declined "only" 50%, according to Kiplinger's Personal Finance Magazine.

This portfolio - diversified in a way that's supposed to diffuse risk - would actually have plunged a full 57% during that same stretch.

The message is clear. In a world in which entire countries are leveraged to the hilt, in which out-of-control financial institutions are calling the shots, and in which clueless regulators are playing a constant game of catch-up, that diversification strategy is no safe harbor.

What you really need to do is seek out investments that move in opposite directions when the investing outlook turns negative.

Hedge funds do this all the time by combining investments that are in favor with those that aren't - pairing those things they like against those things they don't in what's called a classic "long-short" strategy. This helps them generate higher, more-consistent profits - regardless of whether the markets want to run higher or fall lower. And it's a strategy that doesn't force you to try and "time" the markets, or take excessive risk.

You can do the same thing using two investments that are among my personal favorites:

•The Vanguard Wellington (VWELX).
•And the Rydex Inverse S&P 500 Strategy Fund (RYURX).

Vanguard Wellington is one of the world's best-run mutual funds and has a remarkable track record of stability, solid returns and high income that dates back to 1929 - making it one of the longest-established mutual funds in existence today. At a time in which exchange-traded funds (ETFs) are all the rage, many folks scoff at old-fashioned mutual funds. But with an expense ratio of only 0.30%, the Vanguard Wellington is one of a very few funds I believe to be worth it.

The Rydex Inverse S&P 500 Fund is one of a specialized class of so-called "inverse" investments, and is truly "negatively correlated" to the markets, which means that it rises when the S&P 500 falls. Its expense ratio is 1.44%.

For the sake of discussion, let's say you put $50,000 in each on Jan. 1, 2000, and then let the funds ride undisturbed until June 24 of this year. Combined, you'd have an expense ratio of 1.74%.

But even more important, you'd have a 4.18% return over the last 11 years - compared to the S&P 500, which suffered a 12% decline (see accompanying chart).


In other words, had you split your money between these two negatively correlated choices on Jan. 1, 2000 - and just walked away - you'd have trounced the S&P 500 by nearly 16.2% over the last 11 years. That's a much simpler - and more effective - strategy than anything most folks were employing at the time, which was to diversify their money across the key asset classes and then just hold on.

In fact, this "personal-hedge-fund" (long/short) strategy would even have outpaced "indexing." Indexing was another investing strategy that was in vogue a decade ago, but has lost a lot of its following due to the currently uncertain investing outlook.

The classic "long/short" strategy as I've described it is a great choice for investors who are really worried about what may happen next. And it doesn't just work for stocks - you can use it for bonds, too.

In fact, let me show you how.

The Investing Outlook for Fixed Income
Many investors, particularly those who are closer to their sunset years, are loath to get back into the stock market in any way, shape or form - especially given the current investing outlook. It doesn't help that many of these same investors saw their stock-market holdings get "halved" twice in the past 10 years.

So these folks have turned to bonds and the income they provide as a means of sustaining themselves.

The problem with this strategy is that our nation is literally drowning in debt and the bond market is every bit as suspect as the stock market - and maybe even more so, given that Team Bernanke at the U.S. Federal Reserve seems hell-bent on keeping interest rates artificially low as part of its well-intentioned but badly flawed "all gain - no pain" bailout plan.

The good news is that bond investors, like their stock-investing brethren, have alternatives. That's especially true if they want to use a bond-only variation on the classic "long/short" strategy we've just discussed.

My favorite choice here is the Forward Long/Short Credit Analysis Fund (FLSRX), which takes both long and short positions in municipal bonds, corporate bonds and U.S. Treasuries. It can also invest in interest-rate swaps, credit default swaps, futures, options and even sovereign debt.

It's net annual expense ratio is a high 3.22%, according to YahooFinance, but the 4.41% yield and beta of 0.09 help make up for that when it comes to stability.

In fact, since its inception in 2008, the fund has demonstrated very little, if any, correlation with the bond markets - which is exactly what we want and is just why I'm suggesting it.

The Forward Long/Short Credit Analysis Fund is best-suited to investors who want to hold bonds, or must hold bonds, but who are concerned by the risks associated with potential bond defaults, or the rising interest rates and inflation ahead.

One Last "Alternative"
With one eye on the recovery and one eye on the monster that may surface from under their beds, investors have gotten a lot more interested in alternative investments.

That's good because most investors have historically ignored alternative investments. But it's also bad because investors often have an overly narrow view of what an alternative investment can be. Too many investors view commodities as the only type of alternative investment, and commodities can be every bit as volatile as the overall markets - and sometimes even more so.

That's why I think making a slight refinement to include an "alternative alternative" makes sense.

Take the Calamos Market Neutral Income A (CVSRX), for instance. As the name implies, the fund's goal is to provide a neutral approach to markets that is considerably less volatile than traditional asset-class-based alternative choices. Instead, the fund diversifies itself by investment methods that include covered calls and convertible arbitrage.

This fund offers the best of both worlds for investors interested in bond-like income and steadier returns.

The beta is an ultra-low 0.39 versus the broader market (which carries a beta of 1.0), so I'd say the fund's strategy is paying off. The fees are 1.39% a year, but it seems to me the Calamos investors are definitely getting what they're paying for.

There is a bit of a wrinkle with this investment, however: If you're interested, you're going to have to put the Calamos fund on your "wish list." The fund closed to new investors on Jan. 28, and remains so, while management waits for the investing outlook to change - for interest rates to rise and U.S. companies to resume issuing new convertible debt in earnest.

Source :http://moneymorning.com/2011/06/30/three-ways-to-slash-your-risk-despite-the-negative-investing-outlook/

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