Adding Some Smart-Money Touches

By Aaron Levitt | September 17, 2010 AAA

With the market continuing to tread water over the past few weeks, more and more investors are looking towards alternative strategies to generate returns. As correlations between stocks and bonds have become increasingly similar, discovering non-correlated assets is becoming challenging and more important than ever. Following the lead of endowments and hedge funds, individual's portfolios are filling up with unique asset classes and allocations, such as with commodities and 130/30 tactics. As some analysts predict months of relative stock market underperformance, these alternatives may just be what a portfolio needs in order to get through the upcoming quarters.

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New Models
After taking over Yale University's endowment in 1985, David Swensen has managed to produce an average annual 12% return over the past 10 years. The S&P 500 (NYSE:SPY) sank an average 1.2% and bonds rose only 6% during the same time. This performance can be directly attributed to the fund's new focus on these alternative asset classes. By creating a portfolio that has many independent moving parts, Swensen was able to gain high returns while limiting overall risk. Today, almost all endowments and institutional managers follow Swensen's example. Most hedge funds are designed to dampen volatility and provide diversification benefits to traditional stock and bond portfolios. Individuals tilting a portion of their portfolios towards hedge-fund-like investments can provide many of the same benefits. (Learn more about college endowment funds, read Profitable Investing, Ivy League Style.)

Not Just for the Super Rich
One of the big benefits of the ETF boom is that individual retail investors now have the ability to access private equity, hedge funds and other areas of the market previously off limits. Anyone with a brokerage account can now tap their own hedge fund manager.

The iShares Diversified Alternatives Trust (NYSE:ALT) is probably the best "one-stop shop" for adding a hedge fund allocation to a portfolio. The actively managed fund seeks to capture spreads between assets and asset categories, by going long and short. The ETF is able to engage in yield curve arbitrage with regards to currencies, commodities and bonds, momentum stock strategies as well as shorting indexes. The fund charges 0.95% in expenses (much cheaper than the average hedge fund) and is structured as a limited partnership. Investors can expect a K-1 statement come tax time.

Private Transactions
Companies currently have a record amount of cash on their balance sheets and many are going on acquisition sprees as evident by HP's (NYSE:HPQ) and Dell's (Nasdaq:DELL) recent bidding war for 3PAR (NYSE:PAR). Investors can exploit this trend in M&A through merger arbitrage. The IQ ARB Merger Arbitrage ETF (NYSE:MNA) seeks to profit from the spread from when an acquisition is announced and the final purchase price. The ETF charges 0.75% in expenses.

While not a perfect correlation to the private equity market place, the PowerShares Listed Private Equity (NYSE:PSP) invests in public firms that engage in such transactions. These include holdings in The Blackstone Group (NYSE:BX) and business development companies like Ares Capital Corporation (Nasdaq:ARCC). The PowerShares fund yields 4.02% and charges 0.60% in expenses.

Finally, investors have the ability to engage in various shorting tactics without having to borrow shares or use margin. The ProShares UltraShort S&P500 (NYSE:SDS) makes an ideal hedge against the broad market. While the ProShares Credit Suisse 130/30 (NYSE:CSM) and Credit Suisse Long/Short Liquid ETN (Nasdaq:CSLS) offer long-short transactions within one ticker.

Bottom Line
As the correlations between stocks and bonds gain ever closer to each other, the hunt for non-correlated assets becomes more important. Taking a cue from institutional and hedge fund managers, retail investors now have a sophisticated set of tools at their disposal for finding new and uncorrelated asset classes. The preceding ETFs could be just what a portfolio needs in the upcoming months as the economy drifts sideways. (To learn more, see Hedge Funds Hunt For Upside, Regardless Of The Market.)

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