StreetTalk: Hedging Your Bets

Helen Keller, the deaf and blind woman who inspired millions of people nationwide during the first half of the 20th century, had a unique view of fortune — and the decisions that serve as the foundation of good fortune. "When one door of opportunity closes, another opens," she once said. "But often we look so long at the closed door that we do not see the one which has been opened for us."

In this month's column, we will talk about alternative investments — particularly hedge funds — and why investors who eschew alternative investments may be missing the open door.

WHAT ARE ALTERNATIVE INVESTMENTS?

Alternative investments are Wall Street's answer to the question, "Do you have an asset strategy that helps manage risks, offers equity-like returns, and is off the beaten path?" Alternative investments are assets that differ from traditional marketable investments. By and large, they combine higher risk, higher return (relative to traditional investments like stocks) investments, professional management and, most importantly, have a low correlation to "old school" asset classes. This low correlation creates significant portfolio benefits through diversification (risk reduction) and return enhancement. Examples of alternative investments are hedge funds, real estate, commodities, and private equity vehicles (pools).

Brian O'Connell

The goal of alternative investments is straightforward: to capitalize on market inefficiencies while neutralizing the overall direction of the capital markets and interest rates. Alternative investments use techniques and instruments that are unavailable to traditional investment approaches. Money may be invested in either listed or unlisted companies or securities. Alternative investments include hedge funds, private equity pools, real estate, oil and gas, and timber, real estate and other non-traditional strategies.

Wall Street is just beginning to give alternative investments their due. Over the last five years, alternative assets have been the fastest growing investment strategy in institutional investment markets, with average alternative investment asset allocations as high as seven percent in their portfolios, according to General Motors Investment Management Corporation. Alternative investments are proving especially popular with public funds, endowments, and foundations (some of whom earmark 20% of assets to alternative assets). Now, midway through the first ten years of the 21st century, investors have poured over $100 billion into alternative assets.

HEDGING CALMS THE EMOTIONS

There are plenty of ways to invest in biopharm stocks and plenty of ways to manage risk when doing so. I just happen to think that alternatives offer a great way of hedging your bets so that you can better manage risk in otherwise — let's face it — significantly speculative portfolios filled with biopharm stocks. Furthermore, I think alternatives offer some great, built-in protection against the emotional side of our psyche when we use our money to make speculative bets on companies and industries.

As much as we'd like to make our investment decisions with the cold calculation of a computer, our emotions and our behaviors often won't let us. This can complicate the process of evaluating investments that don't fit the traditional mold. Recent history comes into play as well. As the technology bubble of the late 1990s demonstrated, it's easier and less complicated to follow the herd than to do our homework and get a reliable barometer on a stock's potential direction, whether up or down.

But when the bubble burst, investors learned a lesson in financial behavior they'll never forget. That bubble was a classic case of everyone following the herd — right off a cliff. There, the enthusiasm for technology stocks and the sustained bull market was based on the shaky premise that everyone was buying, so everyone bought.

Alternative investments can be a good way to protect you from the herd mentality. In the minds of too many investors, traditional stocks and bonds represent a "sure thing" compared to non-traditional investments, which the investing public views, fairly or unfairly, as being too risky. On Wall Street, we call such a mind set as being "risk averse," that is, opting for a supposedly safe investment over a risky alternative that may offer higher rewards.

Some Wall Street observers maintain that investors, by and large, are a prideful group that naturally feels upbeat about investments that do well and deep remorse over investments that go sour. Just as naturally, remorse trumps pride every time. With remorse comes regret along with a healthy dose of second-guessing.

Remorse also brings with it the sleepless nights and anxious days that may come with an investment decision that inflicted significant financial damage. That's why many investors shy away from investment categories — like biotech and pharmaceutical stocks — that might, in their opinions, inflict some harm on their investment portfolios.

WALK THROUGH THE OPEN DOOR

Mutual funds are entering the market in a big way, creating an entry point for alternative investments. Most funds, at least those that relate to the biopharmaceutical sector, use alternatives to hedge their speculative stock market bets. Some also use off-the-beaten-path techniques to make money in fast-moving sectors like the biopharmaceutical market.

Yes, such funds can be quirky - but also highly useful and productive. The Merger Fund (MERFX), for example, favors businesses that are takeover targets, waiting patiently for the stock price to rise to the takeover stock level. In an industry as volatile as the biopharm market, that's a decent way to make a buck. Another hedge fund — the Equus II (EQS) Fund — is a closed-end fund that targets venture capital firms and leveraged buyouts. Again, the biopharm industry offers ample opportunities in both venues. The fund's performance has also been off the charts in recent years.

If you think the industry is headed toward a downward slope, then you might want to consider a hedge fund that accommodates that line of thinking. The Rydex Ursa (RYURX) Fund does so by betting against the stock market by short-selling futures on the S&P 500. Of course, when the bulls are running, you probably don't want to get too close to such a bearish fund, hedge strategy or not.

A good way to keep abreast of the alternative investment markets is to log on to Alternative Investment News at www.iialternatives.com. The site offers daily updates on alternatives and hedge fund news. It also includes profiles and interviews with leading hedge fund managers and industry analysts. News on private equity and real estate investing is also included. Another web site, Hedge World (www.hedgeworld.com) is worth checking out, as well.

I am not recommending that investors should pile 100% of their financial resources into hedge-friendly alternative investments. But, every investor should consider using alternatives to augment traditional investments, to reduce risk, and to beef up returns. Just bone up on what alternatives can do and buy them wisely. In fact, consider them analogous to prescription drugs. Used correctly, and under the guidance of a knowledgeable professional, they can create incredibly positive outcomes for their users.