July 15, 2010

We are in one of the ugliest periods in history. The economy is incredibly weak. The government is going to print money to fund enormous deficits for the next three to five years, and after a period of deflation we’ll have severe inflation around 2015.

To survive as an investor in such a volatile environment, you need to have a very flexible thought process. In a low-growth economy, you are not likely to have a high-growth investment world. If you buy and hold U.S. equities and bonds for the next decade, you’ll probably get a 6 percent return on equities and maybe 2 percent on bonds. This is where alternative investments come in. Alternatives like managed futures are going to get you around a high single-digit or low double-digit return. Managed futures funds can invest in everything—stock indices, bond indices, currencies, interest rates, metals, energy, and agriculture. They can be long or short almost any benchmark. They can play very short-term trends, and they don’t move similarly to the market. That flexibility makes a lot of sense in a volatile market.

I recommend investors have 5 percent to 10 percent in these funds. There are a few mutual funds that invest in managed futures this way, such as the Rydex/SGI Managed Futures Strategy Fund (RYMTX ) that came out a few years ago. And now there’s the AQR Managed Futures Strategy Fund (AQMNX ).

A lot of new alternative mutual funds have high charges. We’re O.K. with that if the strategy works. We look at the additional cost as the cost of insurance. You have to judge whether that additional expense over a Standard & Poor’s 500-stock index (MHP ) fund is worth it. For instance, we use the Merger Fund (MERFX ) and the Arbitrage Fund (ARBFX ) as a replacement for a portion of our equity strategy. Their expenses are higher, but they’ve outperformed the S&P 500 by 5 percent or 6 percent per year over the last decade.

The problem with many newer long-short funds is that they are, for the most part, long only. They use some shorting to temper the downside but not enough to prevent the downside, so some fell as much as 40 percent in 2008. The long-short fund we like the best is Caldwell & Orkin Market Opportunity Fund (COAGX ). It usually is negatively correlated to the market, so as a portfolio component I give it five stars because it stabilizes your portfolio. It’s had some phenomenal years when the market has been negative and also some good years in the 1990s when the market was up.

We also recommend investors replace half their bond investments with funds such as the Eaton Vance Global Macro Absolute Return Fund (EAGMX ), which can invest in bonds all over the world and go long or short currencies as well as invest in derivatives. The steadiness of the return of that fund has been awesome.

The Stats: Louis Stanasolovich is founder of Legend Financial Advisors, an investment advisory firm managing $380 million. He is also editor of Risk-Controlled Investing. a monthly newsletter focused on alternative low-risk investment strategies, and a co-founder of The Alpha Group, which manages more than $4 billion.