MONEY alternative assets

The Risky Allure of ‘Go-Anywhere’ Bond Funds

It's okay to let your bond managers roam, just don't let them run completely wild.

This is the fifth in a series of five articles looking at the most popular bond alternatives and the safest ways to use them to improve your income prospects when rates are low. Adapted from “Reaching for Yield” in the January/February issue of MONEY magazine.

At a time when traditional routes to investment income aren’t paying off, it’s only natural to seek out pros who are willing to go off the beaten path. Enter “unconstrained” bond funds.

The appeal of these actively managed portfolios is that they’re not bound to invest only in the low-yielding government and corporate debt. Instead, they buy anything—foreign debt, asset-backed securities, stocks, preferreds, and even derivatives—to boost yields and hedge against price drops if interest rates rise.

Sounds good in theory. Alas, there’s no proof that derivatives and other exotica lead to better results. Pimco Unconstrained Bond, one of the biggest funds in the group, is up 2.8% annually over the past three years—that’s less than the plain-vanilla Vanguard Total Bond Market Index Fund. Plus, unconstrained bond funds are expensive, with average fees of 1.3% of assets, vs. 1% for the average bond fund and 0.28% for bond index funds.

Your best strategy: Let your managers roam—just don’t let them run completely wild. Before unconstrained bond funds came along, investors who wanted to give their managers a longer leash turned to multisector bond funds. These fixed-income portfolios also allow managers to invest in a wide variety of assets, such as junk and foreign debt, in addition to high-quality bonds. However, these funds typically set boundaries over what those areas are—and how much of the fund can wander there. This reduces risk, which should help to limit losses in bad markets. The approach also results in lower costs; the typical multisector bond fund has annual fees of 0.8% of assets.

T. Rowe Price Spectrum Income ­T. ROWE PRICE SPECTRUM INCOME RPSIX 0.08% , for instance, can stray into emerging-market bonds and floating-rate bank loans, but only up to 10% of assets for each. This has been enough freedom for Spectrum Income to beat the Barclays Aggregate U.S. Bond index over the past three, five, 10, and 15 years. The same goes for Loomis Sayles Bond LOOMIS SAYLES BOND FUND RET LSBRX -0.2% , a MONEY 50 fund that has also ­beaten at least 80% of its peers over the past three, five, 10, and 15 years.

Recognize, though, that while boosting your investment in multisector bond funds and other alternative assets can help boost your yield, the strategy isn’t a cure-all. Shifting 20% of a portfolio split fifty-fifty between stocks and traditional bonds into a mix of higher-paying alternatives might raise your yield from about 2% to 2.6% with little additional risk, says Geoff Considine, who runs the portfolio modeling firm Quantex. If you’re retired, that means you’ll still probably have to rely on principal and capital gains to fund at least some of your living expenses.

You might prefer to just cash dividend checks to pay the bills and leave the rest of your savings intact—but in reality, where you pull the money from isn’t that important, says Chris Philips, a senior investment analyst at Vanguard. Says Philips: “What really matters is maximizing the total return of your whole portfolio.”

More in this series:
The Smart Way to Invest in Dividend Stocks
High-Yield Bonds: Where to Look for Quality Junk
How Real Estate Can Boost Your Income in Retirement
How to Boost Returns When Interest Rates Totally Stink

MONEY alternative assets

Finding Bargains in Cheap Oil

With oil plunging, these energy investments no longer look as expensive as they did last year.

This is the fourth in a series of five articles looking at the most popular bond alternatives and the safest ways to use them to improve your income prospects when rates are low. Adapted from “Reaching for Yield” in the January/February issue of MONEY magazine.

Like the real estate investment trusts we mentioned previously, master limited partnerships pass on to investors most of the income they generate from their core business, typically storing or transporting oil, natural gas, and other energy resources. And like REITs, MLPs spent much of 2014 looking frothy. In the 10 years through September, these shares nearly doubled the gains of the S&P 500. As a result, by fall MLPs were yielding only 2.7 points more than 10-year Treasuries, vs. their typical premium of 3.2 percentage points.

Since then, the partnerships have suffered a sharp reversal. As fears of a global slowdown grew, oil prices slid by more than half to $46 a barrel, and skittish investors started dumping MLP shares. That has pushed the average MLP yield up to 6.2%, which means they’re now paying more, relative to Treasuries, than they have historically.

Many analysts believe the panic has been overdone. While a minority of MLPs are involved in drilling and oil production, most are pipeline companies that simply collect transmission fees, with much of their revenues set by long-term contracts.

Still, these complex investments aren’t for everyone. As a result of the partnership structure, payouts from MLPs are considered a return of capital, on which taxes are ­deferred until you sell. That tax ­benefit can create a paperwork nightmare, since you may have to file separate tax returns in states the company operates in so there is a government record of the income you’ve received, notes Tom Roseen, head of research services at Lipper. You can invest via a fund that will eliminate the need to file, but that is likely to reduce your returns.

Your best strategy: Since these are still rocky times in the energy sector, your best bet is to go with a fund that gives you exposure to a diversified collection of MLPs. Stick with a fund that focuses on pipeline companies and that won’t tie you up in tax knots. That means investing via an ETF that’s set up as a corporation, not as a partnership.

One fund that meets all the criteria, says Kinney: the Alerian MLP ETF ALPS ETF TRUST ALERIAN MLP ETF AMLP 0.77% , which tracks an index of pipeline MLPs. It paid out 6.25% last year. But thanks to the pullback in share prices and a 4% hike in its distributions in 2014, buyers are likely to collect a yield of almost 7% in 2015. Because it is a corporation, not a partnership, Alerian can’t defer taxes on its payouts; that gets rid of the hassle of filing multiple state returns every year. But convenience comes at a price: The tax bite dampens Alerian’s total return relative to other MLPs. If you’re focused on income, though, that 6% to 7% yield may be ample compensation.

More in this series:
The Smart Way to Invest in Dividend Stocks
High-Yield Bonds: Where to Look for Quality Junk
How to Boost Returns When Interest Rates Totally Stink

MONEY alternative assets

How Real Estate Can Boost Your Income in Retirement

REITs have been hot for a while. But there's still a corner of the market that has room for growth.

This is the third in a series of five articles looking at the most popular bond alternatives and the safest ways to use them to improve your income prospects when rates are low. Adapted from “Reaching for Yield” in the January/February issue of MONEY magazine.

High demand over the past year for the traditionally lofty yields on ­real estate investment trusts—the trusts are required to pay out 90% of their profits—has led to spectacular returns. Among the most popular REIT funds, for example, iShares Real Estate Fifty ETF and longtime MONEY 50 member Cohen & Steers Realty both gained more than 27% in 2014.

The rally has resulted in skimpy payouts for new investors: REIT index funds were yielding about 3% by year-end, far below their 7.5% historical average.

That’s led many analysts, such as Brad Thomas, editor of The Intelligent REIT Investor newsletter, to urge investors to be very picky about where they put new money. One pocket of opportunity now, he says, can be found in health care REITs, which specialize in leasing space to nursing homes, hospitals, and other medical facilities and will profit from the aging of the population. While their high P/Es may be off-putting—some are selling at more than 40 times earnings—a better way to assess REITs is to look at their funds from operations, or FFO. Whereas reported earnings treat depreciation on real estate holdings as an expense that lowers results, FFO adds depreciation back, which more accurately reflects the value of a trust’s property. Using that metric, health care ­REITs look relatively inexpensive, trading at 14.5 times FFO, compared with the industry’s average of 15.5.

Your best strategy: While you’re usually better off investing via mutual funds and ETFs, there are none now that substantially overweight health care trusts. That’s why ­Thomas and Morningstar senior REIT analyst Todd Lukasik instead favor individual health care REITs.

Both, for example, are fans of Ventas VENTAS VTR 0.94% , which owns about 1,500 senior housing communities, skilled nursing facilities, and similar properties in the U.S. and Britain and was recently selling for 15 times FFO. Ventas raised its dividend 9% in December, giving it a yield around 4%. They also like HCP Inc. HCP, INC. HCP 1.39% , which owns $22 billion worth of medical-related property. It is selling for 12 times FFO and yields 4.5%.

More in this series:
The Smart Way to Invest in Dividend Stocks
High-Yield Bonds: Where to Look for Quality Junk
How to Boost Returns When Interest Rates Totally Stink

MONEY alternative assets

High-Yield Bonds: Where to Look for Quality Junk

High-yield bonds are paying more than they did a year ago, but investors still need to stay away from the junkiest junk.

This is the second in a series of five articles looking at the most popular bond alternatives and the safest ways to use them to improve your income prospects when rates are low. Adapted from “Reaching for Yield” in the January/February issue of MONEY magazine.

Falling oil prices have really pummeled the high-yield bond universe, where energy issues make up 15% of the market. Worried that these developments raise the risk of defaults for junk—issues rated BB+ or ­lower —investors have been selling their bonds. That has driven yields up sharply as new buyers demand higher payments to offset greater risk.

That’s a big change from last year, when you might as well have called these securities the “bonds formerly known as high yield.” Halfway through 2014, amid high demand, junk was paying just 3.4 percentage points more than Treasury securities of similar duration—well below the long-term average premium of 5.8 points and a world away from the yawning 20-point gap during the financial crisis in late 2008.

Now the yield gap is back near the norm. “The spreads are close to fair value,” says Marty Fridson, chief investment officer at Lehmann Livian Fridson Advisors. Fridson believes the fall in oil will turn out to be a positive for junk investors: “Eventually the economy will benefit from lower oil prices, which will help the 85% of high-yield bonds not in the energy sector.”

Stay away from the junkiest junk, though, where yields aren’t good enough to justify the higher default risk, says Gershon Distenfeld, director of high yield at AllianceBernstein. According to Standard & Poor’s, 65% of issues rated CCC to C historically have defaulted within five years, compared with 3.4% for BB-rated bonds. Sure, the C’s yield a lot more—11.3%, vs. 5% for BB’s—but that won’t matter if the issuer stops making payments.

Your best strategy: Focus on funds that overweight bonds rated BB+ through B, which are still paying roughly twice as much as Treasuries. Jeff Tjornehoj, head of Lipper Americas Research, calls USAA High Income Fund USAA HIGH-YLD OPPORTUNITIES FD USHYX 0.12% “a stellar performer” because of its ability to manage risk while still providing high returns. The fund was recently yielding about 6% and has only 8% of its holdings in C-rated bonds. Morningstar analyst Sarah Bush also praises the conservatism of Vanguard High-Yield Corporate VANGUARD HIGH-YIELD CORPORATE INV VWEHX 0.17% , yielding 6%. The fund has 93% of its portfolio in bonds rated B or better and a ­razor-thin expense ratio of 0.23%.

More in this series:
The Smart Way to Invest in Dividend Stocks

MONEY alternative assets

How to Boost Returns When Interest Rates Totally Stink

People climbing over wall to greener yard
Mark Smith

With bond rates looking bare, income investors are eager to grab greener options. Higher payouts are out there, but watch your step: Some are riskier than others.

This is the first in a series of five articles looking at the most popular bond alternatives and the safest ways to use them to improve your income prospects when rates are low. Adapted from “Reaching for Yield” in the January/February issue of MONEY magazine.

Falling oil prices have sent shudders through the financial markets lately, but if you’re investing for income, this development could actually spell opportunity. Over the past few years, as rates shriveled on traditional bonds, yield-starved investors poured billions into higher-yielding alternatives, including dividend stocks, real estate investment trusts, energy partnerships, and new “go-anywhere” bond funds. That paid off handsomely if you got in early enough but has been problematic lately: All that money flooding in caused prices to rise sharply on bond alternatives, which sent yields plummeting. As a result, many of these securities by late last fall were paying out half as much as they usually do—or less.

That is, until recently. Jitters over what sharply declining energy prices might mean for the economy have ­prompted a rush back into government bonds and other “safe” securities. As a result, yields on some alternative assets are rising—and you can once again find payouts ranging from 4% to more than 6%, compared with the measly 1.9% rate on 10-year Treasuries.

To get to greener payouts, though, you have to climb a wall of risk. Historically, when market conditions turn sour, alternative assets lose more money, sometimes a lot more, than traditional fixed-income investments. That’s why financial advisers such as Mitch Reiner, chief operating officer of Capital ­Investment Advisers in Atlanta, recommend limiting the amount you invest in them to 5% to 25% of your portfolio, depending on how much income you need and whether you could let losses ride during market setbacks.

Also recognize that while these alternative assets can help boost your yield, the strategy isn’t a cure-all. Shifting 20% of a portfolio split fifty-fifty between stocks and traditional bonds into a mix of higher-paying alternatives might raise your yield from about 2% to 2.6% with little additional risk, says Geoff Considine, who runs the portfolio modeling firm Quantex. If you’re retired, that means you’ll still probably have to rely on principal and capital gains to fund at least some of your living expenses.

What follows is the first in a series of five articles looking at the most popular bond alternatives—in this case dividend stocks—and the safest ways to use them to improve your income prospects.

Dividend stocks: Go global and preferred

High-quality stocks that return a hefty portion of profits to shareholders via dividends are a favorite of income investors when bond yields are low. That’s been especially true over the past few years, when many blue-chip and even some tech companies were yielding as much as or more than Treasury bonds. The same payouts with real growth potential—slam dunk, right?

Not so much anymore. Yield-hungry investors have been bidding up prices on dividend payers since the financial crisis, and despite the market’s recent slide, they still look expensive relative to their earnings. For instance, the average stock in the SPDR S&P Dividend ETF, which tracks an index of companies that have boosted payouts consistently over the past 20 years, was recently selling at more than 18.6 times projected earnings. The price/earnings ratio for the Standard & Poor’s 500, which historically has commanded a higher multiple than slower-growth dividend stocks: about 16.

The more stock prices race ahead of earnings, the more likely they are to fall, warns James Stack, president of InvesTech Research of Whitefish, Mont.  “We are in the sixth year of a bull market,” he warns, adding: “A retirement portfolio can be destroyed reaching for yield.” And while high-dividend shares typically drop less than the average stock during downturns, their losses are still substantially more on average than you could expect with bonds.

Your best strategy: Rather than seeking out the highest yields, zero in on companies that consistently raise dividends. And don’t overpay. To avoid that, look for dividend payers overseas, where stocks have been less inflated than in the U.S.  A good option: PowerShares International Dividend Achievers ETF POWERSHARES INTERNATIONAL DIVIDEND ACHIEVERS PORTFOLIO PID 0.22% , a MONEY 50 pick that invests in foreign companies that have hiked dividends for at least five years straight. It paid out 3.9% over the last year yet has a modest average portfolio P/E of 14.

Preferred stocks offer even higher yields, recently averaging 6%. These shares can be traded like regular stocks but have more in common structurally with bonds: Their payments tend to be fixed over time, and their shareholders are ahead of common stock owners in the pecking order of whom companies must pay first. What you give up in exchange for that reliable income: a shot at much appreciation, because preferred shares, like bonds, have set redemption prices. And like bonds, preferreds are also sensitive to interest rates. If rates jumped, your shares could lose value, as they did in 2013.

Preferreds also lack diversification; almost 90% of them are issued by financial institutions. To reduce your exposure to banks, James Kinney, an adviser in central New Jersey, suggests splitting your preferred stake between iShares U.S. Preferred Stock ETF ISHARES TRUST U.S. PREFERRED STOCK ETF PFF 0.2% and Market Vectors Preferred Securities ex-Financials MARKET VECTORS ETF PFD SECS EX FINLS ETF PFXF 0.1% , which counts blue chips like United Technologies and Tyson Foods among its top holdings.

More in this series:
High-Yield Bonds: Where to Look for Quality Junk

MONEY alternative assets

Lending Club’s $4 Billion IPO Puts Peer-to-Peer Lending in the Mainstream

IOU note
Getty Images

Lending Club priced its IPO on Monday, putting it in the ranks of the biggest public offerings ever for an Internet company. Here's what you need to know about peer-to-peer lending.

UPDATE: On Monday, peer-to-peer lending company Lending Club announced it would be pricing its upcoming IPO at $10 to $12 a share in an effort to raise as much as $692 million. (Click here to read the filing.) At the midpoint of the range, that would value the company at around $4 billion. Now that P2P lending has firmly entered the mainstream (and then some), it’s worth looking again at the advice we published in August, when Lending Club filed to go public, on how P2P lending works and how best to use Lending Club and similar services.

Your bank makes money off borrowers. Now you have the opportunity to do the same. One of today’s hottest investments, peer-to-peer lending, involves making loans to strangers over the Internet and counting on them to pay you back with interest. The concept may be a bit wacky, but the returns reported by sites specializing in this transaction—from 7% to 14%—are nothing to scoff at.

Investors aren’t laughing either. Lending Club, one of the leading peer-to-peer lending companies, filed to go public on Wednesday. The New York Times reports the company is seeking $500 million as a preliminary fundraising target and may choose to increase that figure.

Such lofty ambitions should be no surprise, considering that the two biggest P2P sites are growing like gangbusters. With Wall Street firms and pension funds pouring in money as well, Lending Club issued more than $2 billion of loans in 2013, and nearly tripled its business over the prior year. In July, Prosper originated $153.8 million in loans, representing a year-over-year increase of over 400%. The company recently passed $1 billion in total lending. “A few years ago I would have laughed at the idea that these sites would revolutionize banking,” says Curtis Arnold, co-author of The Complete Idiot’s Guide to Person to Person Lending. “They haven’t yet, but I’m not laughing anymore.”

Here’s what to know before opening your wallet.

How P2P Works

To start investing, you simply transfer money to an account on one of the sites, then pick loans to fund. When Prosper launched in 2006, borrowers were urged to write in personal stories. Nowadays the process is more formal: Lenders mainly use matching tools to select loans—either one by one or in a bundle—based on criteria like credit rating or desired return. (Most borrowers are looking to refi credit-card debt anyway.) Loans are in three- and five-year terms. And the sites both use a default investment of $25, though you can opt to fund more of any given loan. Pricing is based on risk, so loans to borrowers with the worst credit offer the best interest rates.

Once a loan is fully funded, you’ll get monthly payments in your account—principal plus interest, less a 1% fee. Keep in mind that interest is taxable at your income tax rate, though you can opt to direct the money to an IRA to defer taxes.

A few hurdles: First, not every state permits individuals to lend. Lending Club is open to lenders in 26 states; Prosper is in 30 states plus D.C. Even if you are able to participate, you might have trouble finding loans because of the recent influx of institutional investors. “Depending on how much you’re looking to invest and how specific you are about the characteristics, it can take up to a few weeks to deploy money in my experience,” says Marc Prosser, publisher of LearnBonds.com and a Lending Club investor.

What Risks You Face

For the average-risk loan on Lending Club, returns in late 2013 averaged 8% to 9%, with a default rate of 2% to 4% since 2009. By contrast, junk bonds, which have had similar default rates, are yielding 5.7%. But P2P default rates apply only to the past few years, when the economy has been on an upswing; should it falter, the percentage of defaults could rise dramatically. In 2009, for example, Prosper’s default rate hit almost 30% (though its rate is now similar to Lending Club’s). Moreover, adds Colorado Springs financial planner Allan Roth, “a peer loan is unsecured. If it defaults, your money is gone.”

How to Do It Right

Spread your bets. Lending Club and Prosper both urge investors to diversify as much as possible.

Stick to higher quality. Should the economy turn, the lowest-grade loans will likely see the largest spike in defaults, so it’s better to stay in the middle to upper range—lower A to C on the sites’ rating scales. (The highest A loans often don’t pay much more than safer options.)

Stay small. Until P2P lending is more time-tested, says Roth, it’s best to limit your investment to less than 5% of your total portfolio. “Don’t bank the future of your family on this,” he adds.

MONEY alternative assets

New York Proposes Bitcoin Regulations

Bitcoin (virtual currency) coins
Benoit Tessier—Reuters

New regulations may make Bitcoin safer. But some people think they will also ruin what made virtual currencies attractive.

Bitcoin may have just taken a huge step toward entering the financial mainstream.

On Thursday, Benjamin Lawsky, superintendent for New York’s Department of Financial Services, proposed new rules for virtual currency businesses. The “BitLicense” plan, which if approved would apply to all companies that store, control, buy, sell, transfer, or exchange Bitcoins (or other cryptocurrency), makes New York the first state to attempt virtual currency regulation.

“In developing this regulatory framework, we have sought to strike an appropriate balance that helps protect consumers and root out illegal activity—without stifling beneficial innovation,” wrote Lawsky in a post on Reddit.com’s Bitcoin discussion board, a popular gathering places for the currency’s advocates.

“These regulations include provisions to help safeguard customer assets, protect against cyber hacking, and prevent the abuse of virtual currencies for illegal activity, such as money laundering.”

The proposed rules won’t take effect yet. First is a public comment period of 45 days, starting on July 23rd. After that, the department will revise the proposal and release it for another round of review.

Regulation represents a turning point in Bitcoin’s history. The currency is perhaps best known for not being subject to government oversight and has been championed (and vilified) for its freedom from official scrutiny. Bitcoin transactions are anonymous, providing a new level of privacy to online commerce. Unfortunately, this feature has also proven attractive to criminals. Detractors frequently cite the currency’s widely publicized use as a means to sell drugs, launder money, and allegedly fund murder-for-hire.

The failure of Mt. Gox, one of Bitcoin’s largest exchanges, following the theft of more than $450 million in virtual currency, also drew attention to Bitcoin’s lack of consumer protections. In his Reddit post, Lawsky specifically referenced Mt. Gox as a reason why “setting up common sense rules of the road is vital to the long-term future of the virtual currency industry, as well as the safety and soundness of customer assets.”

New York’s proposed regulations require digital currency companies operating within the state to record the identity of their customers, including their name and physical address. All Bitcoin transactions must be recorded, and companies would be required to inform regulators if they observe any activity involving Bitcoins worth $10,000 or more.

The proposal also places a strong emphasis on protecting legitimate users of virtual currency. New York is seeking to require that Bitcoin businesses explain “all material risks” associated with Bitcoin use to their customers, as well as provide strong cybersecurity to shield their virtual vaults from hackers. In order to ensure companies remain solvent, Bitcoin licensees would have to hold as much Bitcoin as they owe in some combination of virtual currency and actual dollars.

Cameron and Tyler Winklevoss, two of Bitcoin’s largest investors, endorsed the new proposal. “We are pleased that Superintendent Lawsky and the Department of Financial Services have embraced bitcoin and digital assets and created a regulatory framework that protects consumers,” Cameron Winklevoss said in an email to the Wall Street Journal. “We look forward to New York State becoming the hub of this exciting new technology.”

Gil Luria, an analyst at Wedbush Securities, also saw the regulations as beneficial for companies built around virtual currency. “Bitcoin businesses in the U.S. have been looking forward to being regulated,” Luria told the New York Times. “This is a very big important first step, but it’s not the ultimate step.”

However, this excitement was not universally shared by the internet Bitcoin community. Soon after posting a statement on Reddit, Lawsky was inundated with comments calling his proposal everything from misguided to fascist. “These rules and regulations are so totalitarian it’s almost hilarious,” wrote one user. Others suggested New York’s proposal would increase the value of Bitcoins not tied to a known identity or push major Bitcoin operations outside the United States.

One particularly controversial aspect of the law appears to ban the creation of any new cryptocurrency by an unlicensed entity. This would not only put a stop to virtual currency innovation (other Bitcoin-like monies include Litecoin, Peercoin, and the mostly satirical Dogecoin) but could theoretically put Bitcoin’s anonymous creator, known by the name Satoshi Nakamoto, in danger of prosecution if he failed to apply for a BitLicense.

One major issue not yet settled is whether other states, or the federal government, will use this proposal as a model for their own regulations. Until some form of regulation is widely adopted, New York’s effort will have a limited effect on Bitcoin business. “I think ultimately, these rules are going to be good for the industry,” Lawsky told the Times. “The question is if this will spread further.”

MONEY alternative assets

Why You Don’t Need "Alternative" Funds

Mutual funds that mimic hedge funds are Wall Street's hot new thing. Too bad they hedge away your best shot at returns.

So-called liquid alternative funds are the latest product Wall Street is pushing on retail investors. In 2013, about $40 billion of new investments flowed into the funds, up from $13 billion the previous year. The funds employ the kinds of strategies used by hedge funds, the less-regulated portfolios reserved for institutions and high-net worth investors. For example, in addition to owning investments outright, they’ll go “short”—that is, bet on stocks or market indexes to go down.

Hedge funds have benefited from the mystique of exclusivity, and for a while boasted pretty great returns. Lately, though, their returns aren’t all that impressive compared with what you can make just owning an S&P 500 index fund.

And mutual funds that mimic these strategies haven’t exactly shot the lights out either. For instance, the average market neutral fund, which seeks to deliver gains in both good and lousy markets, has returned only around 2% a year over the past five years, according to Morningstar. That’s about a tenth of the gains of the broad market during that time.

Financial sophisticates will call that an unfair comparison. Fine. But there’s a reason besides performance to give clever-sounding hedge-like strategies a pass.

Consider this deal: I’ll sell you this very nice antique vase. And I’ll let you in on a secret, too. A magic fairy lives inside the vase, and will grant the owner a wish.

You do not really believe in magic fairies. But you might still buy the vase at the right price, because, hey, it’s a nice vase. And if there’s a chance about the fairy…

When you buy a regular stock fund, you’re buying the vase. Most of what you get is the market’s return. When the market goes up, most funds make money. And when the market goes down, most funds go down. Managers try to add a bit of performance on top, by making smarter picks than the competition. But for the most part, if you know how the S&P 500 did this year, you can make a pretty good guess about how your fund did. Even if your manager isn’t all that skilled, you can still do okay so long as the market rises.

Buying a hedge fund, on the other hand, is like paying for the magic fairy without getting the vase.

The classic hedge strategy tries to eliminate or reduce the market factor. There are lots of ways to do this, including chasing illiquid assets or hopping among wildly different asset classes. In a long-short or market-neutral strategy, a manager might look at Apple and Microsoft and decide that Apple is a relatively better investment than Microsoft. By buying Apple and “shorting” Microsoft, the manager can in theory make money in both rising and falling markets, as long as Apple falls less than Microsoft in a down market, and rises more than Microsoft in an up market. (Many hedge strategies are head-spinningly more complex than this, but this captures the rough idea.) Investing in a hedge fund might reduce your market risk, but in return it bets more heavily on the manager’s investment-picking skill.

Skilled managers aren’t as elusive as magical fairies, but for practical purposes they may as well be. After fees, the vast majority of regular mutual funds don’t beat their benchmark indexes. The reason is simple: Almost by definition, the average money manager must deliver the market’s average, minus fees. Though some managers do outperform over time, it’s hard to tell which ones were lucky and which ones have a skill that will persist over time.

It might be that managers of real hedge funds, who have some control over when money comes into and out of their funds, can use the extra flexibility they have to find an edge. But it is doubtful that in the world of mutual funds, which must be able to hand investors their cash back on any given day, that there is a special secret pool of skilled managers who only work for funds where shorting and leverage and other exotic tactics are allowed.

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