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A Way To Get Hedge Fund-Like Performance |
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FORECASTS & TRENDS E-LETTER IN THIS ISSUE: 1. “Hedge Funds” Are Still The Rage 2. But Hedge Funds Are Usually Available Only To The “Rich” 3. Revisiting Third Day Advisors 4. Third Day’s Hedge-Like Qualities 5. The Case For Aggressive Investments 6. Non-Correlation Is The Key Getting Hedge Fund-Like Performance In Your Portfolio As I am sure most readers are aware, “hedge funds” have been the rage in most investment circles over the last several years, really the last decade. Hedge funds have exploded from just a few hundred funds in 1990 to reportedly well over 9,000 today. From a few billion in assets in 1990, hedge funds today have in the range of $1.4 to $2.0 trillion in assets, depending on whose estimates you read (no one knows exactly). The point is, hedge funds have become extremely popular as an investment alternative. Yet hedge funds are often only available to the rich. For one thing, virtually all hedge funds are private offerings that, due to government regulations, are only available to “accredited” investors, those with net worth in excess of $1,000,000 or $1,500,000 in some cases. Some hedge funds are only offered to “super-accredited” investors who must have net worth of $5,000,000 or more.
Furthermore, most hedge funds have very high minimum investment requirements. Since private hedge funds can generally only accept 99 investors (another government regulation), many have minimum investment requirements of $1 million or more just to get in the door, and here we’re usually talking about newer funds; older, more established funds often require $10 million or more to get a slot, if you can get in at all. The point is, most investors are simply shut-out from the hedge fund world, either because they don’t meet the net worth requirements and/or they can’t meet the huge minimum investment requirements. So what does that have to do with me, you ask? Plenty! Since over 90% of US investors do not qualify for most hedge fund offerings, they spend little, if any, time thinking about why they have become so popular among the wealthy. Sure, there are some wealthy individuals who buy hedge funds mainly for the “snob appeal,” but this is rare, in my opinion. The bulk of wealthy investors invest in hedge funds because of the potential benefits they hope to gain within their overall portfolios. What may surprise you is the fact that you can access some of these hedge fund-like strategies in your own portfolio, even if you’re not among the super-rich. In this week’s E-Letter, I’m going to discuss some of the potential advantages hedge funds can bring to a portfolio, and why these advantages are just as important to you as to a multi-millionaire. To illustrate how you can get hedge fund-like strategies in your own portfolio, we will revisit Third Day Advisors, one of the professional money managers I recommend and have highlighted in this E-Letter in 2005 and 2006. This will also give me the opportunity to update you on Third Day’s outstanding performance last year, though past results are not necessarily indicative of future performance. Revisiting Third Day Advisors, LLC In September of last year, I once again wrote about the Third Day Aggressive Program and suggested that it might be an investment you should consider for your portfolio. Many readers responded to that suggestion and requested more information on this program. It’s not hard to see why. Below is a quick performance summary of this program as of the end of 2006:
As you can see, Third Day had another outstanding year in 2006, once again beating the S&P 500 and Nasdaq 100 indexes – net of all fees and expenses. But the real story on Third Day is not that it has outperformed the S&P 500 on the upside. No, the real story is that Third Day has done it with only a fraction of the losses the S&P and Nasdaq indexes incurred during down periods in the market. Notice that Third Day’s “Worst Drawdown” is only –12.2%. Now that’s impressive!
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Third Day’s Hedge-Like Qualities Third Day has been successful in delivering these actual past results by employing two staples of many hedge fund strategies:
Let me explain each of these strategies briefly below. Leverage simply refers to the ability to multiply gains (or losses) on an investment position. In a typical investment, each dollar invested receives a gain or loss allocation based only on the total amount invested. In a leveraged account, however, the same dollar amount invested would receive a gain or loss allocation as if it were a larger amount. For example, in an account that is 50% leveraged, an investment of $10,000 would be traded as if it were $15,000, and be allocated gains and losses accordingly. Long/Short trading, in a nutshell, is the ability to either invest with or against the market. When a position is “long,” it generally has a positive correlation to the market, so when the market goes up, the investment should also go up. When an investment “shorts” the market, its movement is the inverse of the market’s direction, so if the market goes down, a short position should go up in value. The combination of these two strategies provides an investment program with the potential to not only have more “bang for the buck” through the use of leverage, but also the potential to produce gains when the market is actually falling. The key to success, however, is positioning trades on the right side of the market’s direction. Ken Whitley, owner and founder of Third Day Advisors, has developed a systematic approach to trading the volatile equity market using specialized mutual funds that can be long, short or neutral (cash). Third Day’s Aggressive Strategy is a proprietary blend of momentum, trend-following and overbought/oversold indicators. There are six basic indicators that Ken uses to analyze the market, with a number of sub-indicators that also factor into each trading decision. Each indicator “votes” each day on whether to be long, short, or neutral in the market. The relative strength of each indicator then determines to what extent the Third Day program will be invested in the market. The model is 100% “mechanical” (ie – systematic) though Ken does reserve the right to override his system’s signals in the case of something on the order of a national emergency. Third Day uses the Rydex family of mutual funds because they have specialized funds that produce a result equal to double the daily gain or loss of the Nasdaq 100 Index, without having to borrow money on margin. How Rydex can provide this level of performance is perhaps a subject for a future E-Letter, but the net effect is the ability to provide hedge-like strategies to investors other than the wealthy. Since I have discussed Third Day’s detailed strategy in a recent E-Letter, I’ll not repeat it again here. However, you can click on the following link to get more detailed information on the Third Day Aggressive Program. One area where Third Day departs from its hedge fund counterparts is in the area of fees. It is not uncommon in hedge funds to pay a flat 2% or 3% management fee PLUS an incentive fee that may be anywhere from 10% to 20% of profits. Thus, if a hedge fund’s calendar-year gain is 10% after taking out the management fee, the investor would net only 8% after the incentive fee. (10% gain X 20% incentive fee = 2%). Third Day, on the other hand, charges an annual fee equal to a constant percentage of assets starting at 2.5%, billed quarterly in advance. Also, unlike many managed account programs, when fee breakpoints are reached at $500,000 and $1 million investment levels, the entire account receives the lower fee, not just that part that exceeds the breakpoint. And don’t forget that all of the performance information I have provided about Third Day’s Aggressive Program is net of all fees and expenses. As the name suggests, Third Day’s strategy is aggressive, and therefore it is not suitable for all investors. Yet Third Day may be a good consideration for investors with a well-diversified portfolio. Sophisticated investors know that, in the hands of a seasoned professional money manager, a leveraged long/short strategy has the potential to produce favorable results, even though it involves considerable risk. For those of you who may be more aggressive in your investment approach, Third Day also has another strategy called the Ultra Aggressive Program. As a general rule, I consider this to be suitable only for the most aggressive of investors. If you fall into that category, you can learn more about this program by going to our online Advisor Profile, or by calling one of our Investment Consultants at 800-348-3601. The Case For Aggressive Investments While it’s easy to see how a successful alternative investment strategy might attract some attention based on large annual returns, it’s important to remember that those who invest in hedge funds do not always have chasing returns on their minds when they invest. As I discuss in my Absolute Return Special Report, many wealthy individuals are primarily interested in reasonable returns, but with a strong emphasis on risk management. The reason is that many have become wealthy by selling a business or through an inheritance, and they don’t want to take a big chance on losing it. Many of these same individuals will include aggressive strategies as part of their overall portfolio, which seems to go against their absolute return goal. However, this is not necessarily true. Sophisticated investors know that diversification is an important part of prudent investing, and historically, futures funds, hedge funds and alternative investments provided them the ability to diversify beyond the stocks, bonds and mutual funds available to most investors. Diversification into alternative investment strategies offered by hedge funds may seem to go against conventional risk management wisdom, but studies have shown effective investment diversification can actually result in lower overall volatility, even when some of the investments in the portfolio might be deemed “aggressive.” The wealthy also know that the key to successful diversification is to structure a portfolio so that the individual parts are not “correlated” with each other. Correlation is generally defined as the measure of the relationship between two variables. For example, you might say that there is a high degree of correlation between rain and the presence of clouds. In an investment context, correlation seeks to determine the extent to which investments move up and down in relation to each other. As you might suspect, there are different kinds of correlation. You can have positive correlation, where two investments generally tend to move up and down at the same time. You can also have negative correlation where one asset moves up when another moves down and vice versa. Most interesting to us, however, are those that have no (or low) correlation. This means that the two investments’ returns appear to be independent of each other. Assets that have little or no correlation to the overall stock markets tend to be desirable if other factors such as the level of risk and performance are acceptable to the investor. That’s because the performance of the uncorrelated asset is generally independent of what happens in the stock markets. This is why, for example, managed futures programs have been so popular among investors, as they generally have had little or no correlation to the overall stock and bond markets in the past. Correlation analysis is one of the basic foundations of Harry Markowitz’s work in the 1950s that resulted in what we now call “Modern Portfolio Theory,” or MPT. While space does not permit me to go into a full description of MPT, suffice it to say that Markowitz determined that the extent to which you can combine investments with little or no correlation can have a positive effect on the overall portfolio’s performance. I can remember seeing Markowitz’s theory in action a number of years back when my company got its first asset allocation software. I recall entering in all of the parameters that would be consistent with a moderate risk investor, and seeing what kind of asset allocation recommendation came out. As you might imagine, there were stocks and bonds of various market cap levels, but the one that really surprised me was the allocation to emerging market equities, definitely an aggressive market sector. Even today, it would be hard for me to recommend a client go into an emerging market stock fund. Not only do you have the normal company risk, but also the higher degree of economic and political risks involved in emerging economies. Plus, there is a huge currency risk on top of all of this. However, even with all of those drawbacks, emerging market equities as an asset class had little correlation with US stock market indexes, so the software recommended it to balance the allocation. Thus, one reason wealthy investors have been including aggressive investments in their portfolios is because, as a general rule, such strategies are not correlated to their other investments. Another way to say it is that these sophisticated investors deem carefully selected hedge funds and other alternative investments to be a prudent addition to their portfolios based on their risk tolerance and mix of other investments. I think the wealthy tended to invest in such programs through hedge funds and other alternative investments because, as a general rule, this was the only place they could get such sophisticated strategies. Only in recent years have investment products been developed that allowed money managers the flexibility to include leverage and long/short trading in mutual fund portfolios. Mutual fund products offered by Rydex, ProFunds and Direxion families of mutual funds have definitely leveled the playing field, allowing many more investors to have the option of leverage and long/short strategies in their portfolios. Though the playing field is now level, I continue to believe that you should leave investment management in the hands of professionals. As a practical matter, you can go directly to these specialized funds and trade them yourself. However, that could be a recipe for disaster. Without the benefit of a tested strategy, it would be easy to get “whipsawed” by volatile markets, possibly decimating the value of your nest egg. A Non-Correlated Alternative As discussed earlier, I have mentioned Third Day’s Aggressive Program a number of times in the last two years, and my readers have responded accordingly. However, I know that human nature is such that many of those who requested information did so simply because of Third Day’s impressive annual returns. Rather than focusing only on the annual returns, I think it is important to also consider Third Day’s historical drawdown and correlation to the overall stock markets. Fortunately, Third Day’s track record in regard to these two statistics is also impressive. As I have noted in my past discussions about Third Day’s Aggressive Program, its worst-ever month-end drawdown is -12.2%. This represents the worst losing streak this program has endured since its inception in November of 2001. This compares very favorably to the S&P 500 Index’s drawdown in excess of -28% and the Nasdaq 100 Index’s worst loss of over -47% over the same period of time. In addition, Third Day’s Aggressive Program has produced positive returns in each of the past five calendar years, which is no small feat when you consider that its track record includes the year 2002 when the S&P 500 Index fell over -22% and the Nasdaq Composite Index fell over -31%. Past performance is not necessarily indicative of future results. Beyond that, a statistical analysis of the Third Day Aggressive Program shows that it has a 0.00% historical correlation (R-Squared) to both the S&P 500 and Nasdaq Composite indexes. This means that its returns have tended to be independent of the movements of the overall stock markets in the past. Conclusions As the hedge fund industry continues to attract wealthy investors across the world, I hope that I have been able to shed some light on why many of these individuals seek out these risky investments. The key point that you should take away from this E-Letter is that the rich do not necessarily have different investment needs than you do; they have just been able to access a class of investments not readily available to the general public. Fortunately, such strategies are becoming more accessible to investors other than the super-rich. Professional money managers like Ken Whitley at Third Day Advisors have brought specialized strategies such as leverage and long/short trading to a far wider audience than was ever possible under the restrictive hedge fund rules. While it is vitally important that such aggressive strategies be blended with other assets inside a portfolio as a part of a diversification strategy, you now have the ability to consider these sophisticated strategies that were once available only to the wealthy. The minimum investment required in the Third Day Aggressive Program is $50,000. At the same time, I have to caution that Third Day strategies are not suitable for all investors; like hedge funds, they are aggressive investment programs. As always, past performance is not necessarily indicative of future results. If you would like to learn more about Third Day’s aggressive investment strategies and how they may fit within your portfolio, please feel free to give one of our Investment Consultants a call at 800-348-3601. You can also get more information by completing our online request form, or at our website at www.halbertwealth.com. Very best regards,
Gary D. Halbert SPECIAL ARTICLES
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IMPORTANT NOTES: Halbert Wealth Management, Inc. (HWM), Third Day Advisors, LLC, and Purcell Advisory Services, LLC (PAS) are Investment Advisors registered with the SEC and/or their respective states. Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed. Any opinions stated are intended as general observations, not specific or personal investment advice. Please consult a competent professional and the appropriate disclosure documents before making any investment decisions. There is no foolproof way of selecting an Investment Advisor. Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors. HWM receives compensation from PAS in exchange for introducing client accounts to the Advisors. For more information on HWM or PAS, please consult Form ADV Part II, available at no charge upon request. Any offer or solicitation can only be made by way of the Form ADV Part II. Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others. As benchmarks for comparison, the Standard & Poor’s 500 Stock Index (which includes dividends) and the NASDAQ 100 Index represent an unmanaged, passive buy-and-hold approach. The volatility and investment characteristics of these benchmarks cited may differ materially (more or less) from that of the Advisor. The performance of the S & P 500 Stock Index and the NASDAQ 100 is not meant to imply that investors should consider an investment in the Third Day Aggressive Strategy trading program as comparable to an investment in the “blue chip” stocks that comprise the S & P 500 Stock Index or the stocks that comprise the NASDAQ 100. Historical performance data represents actual accounts in a program named Third Day Aggressive Plan, custodied at Rydex Series Trust, and verified by Theta Investment Research, LLC through December 2004. Performance from January 2005 forward is from an actual account in Purcell Advisory Services Third Day Aggressive Program. Since all accounts in the program are managed similarly, the results shown are representative of the majority of participants in the Third Day Aggressive Program. Purcell Advisory Services utilizes research signals purchased from Third Day Advisors, an unaffiliated investment advisor. The signals are generated by the use of a proprietary model developed by Third Day Advisors. Statistics for “Worst Drawdown” are calculated as of month-end. Drawdowns within a month may have been greater. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Mutual funds carry their own expenses which are outlined in the fund’s prospectus. An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency. When reviewing past performance records, it is important to note that different accounts, even though they are traded pursuant to the same strategy, can have varying results. The reasons for this include: i) the period of time in which the accounts are active; ii) the timing of contributions and withdrawals; iii) the account size; iv) the minimum investment requirements and/or withdrawal restrictions; and v) the rate of brokerage commissions and transaction fees charged to an account. There can be no assurance that an account opened by any person will achieve performance returns similar to those provided herein for accounts traded pursuant to the Third Day Aggressive Strategy trading program. In addition, you should be aware that (i) the Third Day Aggressive Strategy trading program is speculative and involves a high degree of risk; (ii) the Third Day Aggressive trading program’s performance may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in the program; (iv) Third Day will have trading authority over an investor’s account and the use of a single advisor could mean lack of diversification and consequently higher risk; and (v) the Third Day Aggressive Strategy trading program’s expenses will reduce an investor’s trading profits, or increase any trading losses. Returns illustrated are net of the maximum management fees, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees. They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. No adjustment has been made for income tax liability. Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss. The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments. |
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