Build Your Own Hedge Fund

If you’re looking for double-digit income, Pakistan has a deal for you. A model of geopolitical instability and down to its last $4 billion or so in foreign reserves, the sanctuary of the late Osama bin Laden has announced that it intends to raise $1 billion through its first bond issue since 2007. Currently, outstanding Pakistani bonds that mature in five years yield 12.3%. That is a rich 11 percentage points more than the yield on U.S. Treasury IOUs of similar maturity. Plus, just imagine if Pakistan’s prospects get better and interest rates drop. Holders of those bonds could reap big capital gains!

If you think that Pakistani bonds are a ridiculous asset to stick in your portfolio, you are not alone. And that is precisely the point. With the Dow Jones industrial average up 5,000 points in two years, I am getting nervous. It’s time to think about investments that don’t march in lock step with U.S. stocks.

No, don’t sell your shares in Google and ExxonMobil to buy Pakistan. You should always invest in stocks for the long run—and don’t fear to hold them even when they seem pricey. But you should also reserve a small part of your portfolio—say, 5% to 10%—for true hedges, investments that don’t move closely with the stock market. In other words, ones that sometimes go up when other assets go down, or that simply go their own way. Call this part of your portfolio your personal rogue hedge fund.

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Individual Pakistani bonds are not easy to buy, and many good emerging-markets debt funds require large minimum investments or charge upfront commissions. The best choice among no-load mutual funds is T. Rowe Price Emerging Markets Bond (symbol PREMX), with a portfolio that includes debt from Ukraine, Venezuela and the Philippines. The fund yields 5.5%—certainly not in the range of Pakistan’s bonds, but twice that of a ten-year U.S. Treasury bond. Expenses are a reasonable 0.94%.

Fund for Bears

The most straightforward hedge, of course, is a bear fund. Dozens of exchange-traded funds are designed to rise in value when the underlying index falls—and, naturally, they fall in value when the index rises. ProShares Short S&P 500 (SH), for instance, declined 24.7% for the year that ended November 29, while the benchmark it matches in reverse, the S&P 500, rose 30.3%. In 2008, when the index plunged 37%, the short fund gained 38.9% (for technical reasons, a perfect inverse relationship between a bear fund and its index is rare).

For my own rogue hedge fund, however, I prefer to short a sector that is doing particularly well. A good choice is ProShares Short Financials (SEF), an ETF that lost an annualized 24% over the past five years. It’s linked to the Dow Jones U.S. Financials index. If bank stocks take a dive (as they are wont to do periodically), the ProShares fund should do well. (Unless otherwise indicated, returns and prices are as of November 29.)

A similar approach is to buy an ETF or mutual fund that is run by a manager who chooses which stocks to sell short (a technique for making money when a stock goes down in value). An example is AdvisorShares Ranger Equity Bear (HDGE), an ETF that, at last word, had short positions in 47 stocks, including Tempur Sealy International (TPX), the mattress maker, and Sally Beauty (SBH), which distributes personal-care products.

The fund’s Web site says its managers look for firms with “low earnings quality or aggressive accounting which may be intended on the part of company management to mask operational deterioration.” Over the past year, the fund is down almost precisely as much as the S&P is up. In addition to being certain to lose money when stocks advance, another of Ranger’s drawbacks is a high annual expense ratio of 1.78%, plus another 1.51% in interest expenses for borrowing shares to sell short.

Another, more personally satisfying strategy is to choose your own shorts from among hot stocks of the moment. In my September column, I suggested Tesla Motors (TSLA, $128), the electric car maker, as a stock to avoid. Since late September, it has fallen 34%, but with a price-earnings ratio of 85 based on predicted earnings for the year ahead, I expect the road to remain bumpy for Tesla shares. Twitter (TWTR, $42), which went public in November, has no P/E because it has no earnings, but its price-to-sales ratio is 42, compared with 17 for Facebook (FB, $47) and 6 for Google (GOOG, $1,060). Or you can stalk a wounded company, such as Caterpillar (CAT, $85), the heavy-equipment maker, whose profits and sales have been dropping but whose stock price is roughly the same as it was a year ago.

Caterpillar, like most companies, has benefited from low interest rates. But if rates rise sharply, it’s a good bet that stocks will fall, as higher borrowing costs hit both businesses and consumers. So will most kinds of bonds. However, a special kind of debt, called floating-rate notes (FRNs), will give investors higher returns because, by definition, their interest payouts increase as rates go up.

The easiest way to buy FRNs is through funds such as Fidelity Floating Rate High Income (FFRHX), which invests in bank loans made to lower-quality borrowers. Typically, the interest rates on the loans are tied to a short-term-rate benchmark and reset every 30 to 90 days. FRN returns have little correlation with the stock market. They deliver above-average yields (the Fidelity fund yields 2.5%) and, unlike most other bondlike investments, they should hold their value as interest rates rise. Be aware, however, that if rates rise too much, these bank-loan funds may take a hit because corporate borrowers may have a hard time repaying their loans.

Another low-volatility choice is Merger Fund (MERFX). The fund (a member of the Kiplinger 25) owns stocks but has consistently produced steady returns that are almost totally uncorrelated with the broad stock market. In 2008, for instance, the fund lost just 2.3%, and in 2009 it gained just 8.5% (compared with a gain of 26.5% for the S&P 500). How? By investing in stocks involved in takeovers and mergers.

The fund’s managers don’t try to predict takeover bids. Rather, they buy the stocks of takeover targets after the bids are announced and hang on till the deals are consummated. The result: small but consistent profits. Merger’s strategy is the opposite of risky, but for an investor seeking a way to balance possible losses in the stock market, it provides excellent ballast.

Commodities are the assets whose ups and downs have been least coupled with stocks’ fortunes. Over the past 50 years, the correlation has been at right about zero. It was difficult for small investors to buy commodities in the past, but you can now invest in many through ETFs.

PowerShares DB Base Metals (DBB), for example, has holdings divided almost evenly among zinc, copper and aluminum. But for my rogue hedge fund, I prefer United States Gasoline (UGA), which, as the name implies, owns gasoline futures contracts. If the price at the pump goes up, you may be shelling out more to drive, but your investment portfolio will be happy. And that is the very definition of a nice hedge.

James K. Glassman, a former UnderSecretary of State, is a visiting fellow at the American Enterprise Institute. He owns none of the investments mentioned.