Jimmy, Freddy the magic flute and Mayor Pufnstuf (right).
H.R. Pufnstuf was the answer to the question, “Who’s your friend when things get rough?” Pufnstuf starred in a Sid and Marty Krofft cult classic TV show which debuted during “the summer of love” in 1969 and continued in reruns as late as 1999. The show’s theme song assured us that Pufnstuff, Mayor of The Living Island, was “your friend when things got rough” because “he knew just what to do.”
(Take care with clicking on that link. I found myself humming bits of a cheery, half-forgotten, possibly drug-tinged theme song for an hour afterward.)
In the series, “rough” was mostly occasioned by the evil Witchiepoo rather than interventionist bankers, inconsistent policy-makers, a rapidly mutating virus or a horde of bored new investors learning to day-trade. As little as we like it, we know that even the most brilliantly-managed, risk-conscious fund is going to suffer terrible losses if the market this fall goes to pot. (Sorry, another Pufnstuf joke.) The Great Owls, the funds with the most consistently excellent risk-adjusted returns, as a group dropped between 13% (Akre Focus, Amana Growth, Brown Advisory Sustainable Growth) and 35% (pretty much anything with “small” or “midcap” in its name) within just a couple weeks. The S&P 500 dropped 35%.
So far, those losses have proven fleeting as the fiercest declines in decades were followed by the sharpest rally. Sadly, we can’t count on that sort of rebound in the financial equivalent of “the second wave.” The losses sustained there can play with your mind, quite as much as your portfolio.
The question for us became, who’s your friend when things get rough?
Simple versus Sophisticated
One simple, perennial answer to that question is RiverPark Short-Term High Yield Fund (RPHYX/RPHIX). We profiled RPHYX most recently in 2017. Managed by David Sherman of Cohanzick Asset Management in New York, RPHYX offers an alternative to strategic cash and short-term debt funds. Mr. Sherman famously invests in orphan securities; profitable short-term investments that have very few logical buyers. Called and redeemed high yield bonds are an example. A corporation might issue a 20-year high-yield bond then, as its finances improve, it can “call” the bond; that is, announce to bondholders that it intends to redeem the bond early. That often happens when a stronger balance sheet allows a corporation to find a way out of onerous high-yield debt payments. When a bond is called, shareholders are generally entitled to one final monthly payout before redemption. On whole, high-yield managers would rather get their principal back right now so they can redeploy the cash; the gain for that last lonely payout is inconsequential to them. Mr. Sherman is willing to buy the bond from them, pocket that last all-but-guaranteed payment and redeem the bond.
Currently, he’s able to buy such ultra-low risk, ultra-short-term securities at a yield higher than the yield on a 30-year Treasury bond.
The fund is particularly attractive to investors in an environment with near-zero interest rates since his strategy is not particularly affected by interest rate moves. The Fed funds rate sat at 0.05% in May 2020, its lowest rate ever. That’s not necessarily an anomaly: the Fed maintained a fund rate under 1% for almost nine years, between 2008-2017.
Since inception, the fund has returned 2.97% annually, with returns of 3.41% during the stretch of a near-zero Fed funds rate. The fund has only had three negative quarters (-0.01 to -0.67%) in its history, it’s never had back-to-back negative quarters and its worst-ever drawdown was 1.09%, from which it recovered in a month (per Morningstar).
Its steady rise and minimal downside leaves it with the highest Sharpe ratio of any fund in existence: 2.68 over the past nine years while the next-best fund sits at 1.8. Since its inception, the fund has capture -2% of the S&P 500’s downside, which is to say that it tends to drift up as the S&P is falling. At the end of July 2020, Cohanzick laid out the case for Why this is the Perfect Market Environment for the RiverPark Short Term High Yield Fund. The fund surged to nearly $1 billion when interest rates last stayed this low and the manager closed it to new investors; during the short-lived rise in interest rates, assets migrated out and the fund drifted down to about $700 million. It would be subject to re-closure if renewed inflows jeopardized Sherman’s ability to execute on his shareholders’ behalf.
Another way of pursuing the same goal – low volatility, market-neutral returns – is provided by the MFO Premium fund screener. We looked for “alternative investment” funds that met three criteria:
- five-year returns of 2% or more. That eliminated half of all alts funds. While you might think this is an awfully low bar, remember that you’re looking for an option for a potential bear market in both stocks and bonds.
- an R-squared of 20 or less, relative to the S&P 500. The goal is to find funds whose returns are unaffected by movements of the stock market. An R-squared under 20 means that less than 20% of a fund’s performance is predicted by how “the market” did.
- a maximum drawdown of 10% or less. That’s because it would not be reassuring to choose a fund “for rough times” only to discover that the danged thing occasionally loses 20 or 30% on its own.
Out of a universe of hundreds of alt funds, those three criteria leave us with a list of just 10 possibilities which I’ve sorted by their five-year returns. The highlighted funds qualify as MFO “Great Owls” for having achieved top-tier risk-adjusted returns in all evaluation periods longer than one year.
|Infinity Q Diversified Alpha IQDNX||Multi Strat||0.16||6.8||-2|
|Arin Large Cap Theta AVOLX||Long/Short||0.04||6.3||-8.4|
|JPMorgan Opportunistic Equity Long/Short JOERX||Long/Short||0.22||4.9||-6.8|
|LoCorr Macro Strategies LFMIX||Futures||0.04||4.4||-8.7|
|Westwood Alternative Income Ultra WMNUX||Mkt Neutral||0.15||3.1||-4.8|
|JPMorgan Research Market Neutral JPMNX||Mkt Neutral||0.03||2.8||-6|
|BlackRock Tactical Opportunities PCBAX||Macro||0.23||2.5||-6.3|
|Cognios Market Neutral Large Cap COGIX||Mkt Neutral||0.07||2.1||-10|
|American Beacon AHL Managed Futures Strategy AHLYX||Futures||0.06||2.1||-9.9|
|T Rowe Price Dynamic Global Bond RPIEX||Macro||0.06||2.1||-3.4|
Infinity Q Diversified Alpha (IQDAX) launched in September 2014, but it is run side-by-side with the firm’s older hedge fund. Like many hedge funds, the mantra is “we can do anything! Let’s see what works.” To describe the mutual fund as “an after-thought” is about fair. The fund’s website is virtually empty, the “investor shares” minimum is $100,000 and the expense ratio is 2.46%.
Arin Large Cap Theta (AVOLX) likewise. High minimum with a website that was out-of-style in 1994.
JPMorgan Opportunistic Equity Long/Short (JOERX) launched in 2014, with Rick Singh, a former hedge fund manager, at the helm since inception. Mr. Singh invests, long and short, in mid- to large-cap stocks based on his assessment of their valuation. He’s got the freedom to range from -30% market exposure – where the market falling by 10% would automatically boost his returns 3% – to 80%, with his next exposure last year being under 60%. His hedging has been successful enough that the fund’s bear market deviation is around 4%. It has a $1,000 minimum and a 2.3% expense ratio.
LoCorr Macro Strategies (LFMAX), a managed futures fund, launched in 2011. Managed futures work so well on paper; that vast majority of them crash-and-burn in practice. LoCorr, so far, has held on. In general, managed futures strategies identify a number of distinct asset classes then flip the switch to either invest in the asset class, or short it, depending on a variety of technical measures. The strategy here is to employ three different specialist sub-advisors, each of whom has their own strengths and specific approach. So far, their down years have seen losses of about 5% while their up years average a bit more than that. $2,500 minimum with 2.25% expenses.
Westwood Alternative Income Fund (WMNAX) launched in 2015. It uses a convertible arbitrage strategy, which sort of translates to “it buys convertible bonds issued by Company X then simultaneously shorts the common stock of Company X,” leaving it with modest, market-neutral gains. The expense ratio is just 0.77%, the investment minimum is $1,000 and the sales charge is avoidable.
JPMorgan Research Market Neutral (JMNAX) is a long-short equity fund with an 18-year track record. Most long-short funds are long-biased; that is, they act as if 60% of their portfolio is invested in stocks. That’s a fine idea of you’re competing with a 60/40 hybrid fund but less wise if you’re trying to free yourself from the effects of the market altogether. With an R-squared of just 3, JPMorgan manages that. The fund is a low minimum and it’s relatively easy to get around the sales charge; sadly, it also sports a 3.4% expense ratio. In effect, 60% of the manager’s gains are eaten by overhead expenses.
BlackRock Tactical Opportunities (PCBAX) has two words for you: “Trust us.” PCBAX is a multi-strategy hedge fund for the masses. And it is, on whole, really quite good. It’s overall correlation to the stock market is minimal and its beta is negative; that is, it tends to rise when the market falls. That might imply that it falls when the market rises which isn’t the case: over the past three years, the fund has returned 4.7% annually or just under half of the stock market’s return while harvesting virtually none of its losses. The key caveat is that the fund’s strategy changed in 2016, from tactical allocation to a focus on avoiding market risks. As a result, it’s long track record – dating back to 1988 – is largely irrelevant. That said, BlackRock is a multi-trillion manager. $1,000 minimum and 1.1% expense ratio.
Cognios Market Neutral Large Cap (COGIX) is a solid long/short fund with a market-neutral mandate and a distinctive strategy. They try to construct a “beta neutral” portfolio, which means that the size of the short portfolio is adjusted so that it contributes the same beta as the long portfolio. That allows, they believe, a more truly market-neutral portfolio. In consequence, they’ve never lost more than a fraction of one percent in a year and frequently post annual gains of 4-6%. You might review our 2016 profile of the fund for details. $1,000 minimum and 1.8% expense ratio after substantial waivers.
American Beacon AHL Managed Futures Strategy (AHLPX) is another managed futures fund. AHL is a British hedge fund firm whose parent company was founded in 1783. They use a quantitative system to toggle between long and short positions in commodities, equity, currencies, and fixed-income. Curiously, 2020 is the strongest performance since launch: they’re up 5.6% through the end of July. $2,500 minimum and 1.9% expense ratio. American Beacon no longer sells directly to the public, so interested parties would need to work through a fund supermarket. That’s why Morningstar flags the fund’s availability as “limited,” which is usually a euphemism for “soft-closed.”
T Rowe Price Dynamic Global Bond (RPIEX) is one of a series of hedge-fund-like offerings that Price has been adding as the broad markets become less reliable. It’s a high turnover, go-anywhere fixed income fund with the ability to hedge currency and interest rate risks. The goal is “attractive” returns each year while “outperform[ing] equities and high yield in periods of market stress.” Low cost, low minimum, first-rate parent. The manager, Saurabh Sud, is a PIMCO alumnus who helped manage their Credit Opportunities fund.
If I were really quite anxious about the prospects for the second half of 2020, where would I consider investing? I have had a position in RiverPark Short Term High Yield, nearly since the fund’s inception. I would be most comfortable looking at the offerings from Westwood, BlackRock, Cognios, and T. Rowe Price.
I would read rather a lot about managed futures strategies before considering either LoCorr or American Beacon. While these funds are both doing a fine job, their records are short and the same strategy in other hands has blown up with some regrettable consistency.
The two JPMorgan funds bear watching. Mr. Singh has done a very fine job though I would want to better understand his hedging since it’s challenging to reconcile a 60% net equity exposure with market-neutral performance. The Market Neutral fund’s expense ratio is troubling.
The bottom of the bottom line: get comfortable now with how your portfolio might perform over the next six months. While many starry-eyed day traders and shills see nothing but rainbows and unicorns, rather a lot of serious managers are deeply disquieted. Laura Geritz, principal of the Rondure Funds and former Wasatch manager, offered a powerful warning in her most recent letter to shareholders:
This hot, hot, hot market reminds our team of their interactions with their children and in the endeavors to teach our children about the risks and danger from the hot gas stove. Currently, when they walk by the stove, they will stick out their hands and parrot, “hot, hot, hot.” While they are able to … repeat the words we’ve tried to teach, they are failing to understand the connection to the consequences that will inevitably come … [when] there will be many, many tears.
It’s becoming more common to hear our friends and others talk about investing. The thing is, they often parrot some nugget or cliché of investing – calling out “hot, hot, hot” but their actions belie their understanding.
“Invest in what you know” … they either put all their investible assets into a single stock or daily/weekly rotate through Apple, Facebook, Tesla, Nikola, Google, Nio, and Microsoft. They don’t invest in what they know, they trade what they know – valuation agnostic.
And there will be many, many tears.