Clark at Large: Investing Like the Big Boys

I don’t know if he still does this, but years ago, my old boss Don Phillips (now president of research and communications at Morningstar, Inc.) used to travel around giving brilliant presentations about the outperformance of mutual fund managers who couldn’t be contained into one style box. I can’t remember all his examples, but the ones who stick in my mind are Foster Friess of Brandywine Fund, Jean-Marie Eveillard of SoGen International, and gruff old cigar-smoking Marty Whitman of Third Avenue Fund.

Don would dip into his Morningstar fund data, and regale standing-room-only audiences with example after example of how, over the years, Whitman & Co. had periodically repositioned their portfolios across the investment spectrum to capture whatever opportunities they saw in their crystal balls: from corporate bonds to value stocks; and emerging markets to U.S. real estate. In doing so, their results led the mutual fund industry time after time after time.

Don’s point was that great money managers could feel undervaluation in their bones, and fearlessly followed their instincts whereever they led. Not coincidentally, he was also graphically illustrating the flaw in the Modern Portfolio Theory approach that most independent advisors use to allocate client assets. By doggedly looking for funds that rigidly adhere to a corner of the style box (which, ironically, was created by Morningstar), advisors handcuff managers by preventing them from taking advantage of all the opportunities they see, or ignoring the great managers who do.

Fast forward to late 2008, when all the major asset classes (except Treasuries) took an unprecedented nosedive, and that MPT flaw was exposed in a way that most advisors couldn’t avoid noticing. The entire industry has spent the past year or so wrestling with the question of what to do about it. Some folks believe that a broader basket of asset classes would have dampened the impact of the Mortgage Meltdown. Others are turning back toward market timing, I mean “strategic allocation,” under that hard-to-argue-with notion that if we could just avoid those pesky market downturns, we’d all be a lot happier.

Another approach that seems to be getting a lot of attention from advisors these days is the way institutional and high-net-worth investors have traditionally solved this problem: They reduce risk and still keep portfolios quantifiable by adding low-correlating asset classes while allowing fund managers to take short as well as long positions within their fund parameters. Yes, I’m talking about managed futures and hedge funds here, but before you turn back to your Morningstar Workstation, you might want to look at some of the recent market data–it could change your life.

For starters, let’s consider the past 10 years, ending March 31, which includes two major down markets that I’m sure you and your clients clearly remember. While the S&P 500 Index (total return) was losing 6.36%, or 0.66% per year (that’s right, your clients’ diversified equities probably lost money over the past decade despite last year’s run up), hedge funds (as measured by the HFRI Fund Weighted Composite Index) were up 77%, or 5.9% a year. They nearly doubled in value. And managed futures (by the Altegris 40 Index) were up 115% or 8.0% annually.

Got your attention? Well, it certainly got mine. Sure, with both the dot.com and subprime crashes it was a very tough decade for equities. But that’s the point: How do advisors better protect client portfolios from the market downturns that seem to inevitably occur every seven to 10 years or so? Managed futures and hedge funds seem to offer a pretty compelling answer.

What about compared to real, diversified portfolios? Take a look at the chart below, which compares a $1 million portfolio traditionally allocated between 70% equities (S&P 500) and 30% bonds (Barclays Capital US Aggregate Bond Index) with $1 million split: 45.5% S&P, 19.5% US Bonds, 20% Managed Futures, and 15% Hedge Funds. As you can see, the results aren’t as staggering, but the portfolio with the alternative investments still outperformed dramatically. During the same 10-year period, the traditionally allocated portfolio returned a mere 18.2%, while the addition of 35% managed futures and hedge funds boosted performance by nearly 150%, to a 45% total return. And that with a 28% lower standard deviation (8.0% vs. 11.1%), and the “worst drawdown” (largest spread from peak to valley) reduced 29%, from -37.6% to -26.7%.

Of course, identifying promising new investment strategies is only half the battle–particularly when they’re traditionally institutional. For independent advisors, the bigger challenge is finding investment vehicles that can accommodate their less-than-high-net-worth clients, and still capture those institutional advantages, all at a reasonable cost. When it comes to managed futures and hedge funds, the challenge is even greater.

Two years ago, Mike Capelle, senior vice president of investment management at United Capital Financial Advisors in Newport Beach, California, realized that to attract the affluent clients who are his firm’s target market, he needed to offer more institutional- level investments. United Capital is a “national” wealth management firm, since 2005 consolidating some 23 advisory firms across the country, collectively managing $9 billion in client assets. With a focus on what they call “private wealth management,” United Capital needed to compete with the private banks, which then–and even more so now–meant access to hedge funds and managed futures.