Confessions of a Money Manager: Don't let hedge fund speculators ruin your portfolio

Ray Unger  —  1/09/2009 4:00 pm

OK, 2008 was a disaster and it blindsided just about everyone. The giants of Wall Street ate huge slices of humble pie and precious few escaped the claws of the mighty bear. But it's 2009 now, and hopefully, the tire tracks on our back will help us navigate the rough road ahead.

So what did we learn in 2008? I think we learned that any asset class can be destroyed not because of fundamental weakness but because of irrational trading by those who own that asset. The most obvious example is crude oil. Those who thought demand was pushing the price of crude above $140 a barrel must now acknowledge that speculators with tons of cash -- followed by such stalwart investors as the California Public Employees' Retirement System (CalPERS) -- were creating the oil price bubble that burst in August.

Now we've seen oil prices gyrate. In less than two weeks, it was down to $36 a barrel, then up to $50 a barrel, and down again to $42 a barrel. Such price swings shouldn't surprise us given that hedge fund managers and speculators are still in the oil game. Those who think they can predict their trading patterns are playing with fire.

These same managers can even upset the most conservative of asset classes. Look what happened to municipal bonds last year. iShares S&P National Municipal Bond (MUB $100.25) is an Exchange Traded Fund that essentially duplicates the bonds in the S&P National Municipal Bond Index.

Now, this index is not a junk bond index, yet that's what it traded like in October when it lost more than 15 percent of its principal value because the dominant traders (hedge funds) of municipals acted like drunken Army recruits running from the MPs. That's right, hedge funds loaded up on muni bonds with borrowed capital -- at rates lower than muni bond yields -- to make what they thought was easy money on the yield spread.

Unfortunately, when their gambit backfired, they were forced to sell massive quantities of munis into the traditionally staid muni bond market and prices fell to ridiculously low levels. When the dust settled, however, and the quality issue was resolved, the Exchange Traded Fund regained its former price level.

Thus, the lesson is that when speculators jump into an asset class, no matter the traditional risk parameters, that asset now has more risk. Conversely, when the speculators exit an asset class, there may be buying opportunities.

Thus, it makes sense to divert some of our portfolio to assets that are hidden from these speculators. In recent columns we mentioned several fixed income ideas: iShares Barclays TIPS (Treasury Inflation Protected Securities) Bond Fund (TIP $98.51), BlackRock High Yield Bond Fund (BHYAX $5.28), and to these we would add the iShares S&P National Municipal Bond (MUB $100.25).

In the equity area, we think an old favorite should be revisited, First Eagle SoGen Overseas Fund (SGOVX $16.73). The manager, Jean-Marie Eveillard, employs an eclectic style of buying and holding stocks of companies that lack -- how should I say it? -- pizazz. The fund has dull, staid companies, both large and small, that fly under the radar screens of most speculators.

During the 2000-02 bear market, this fund produced exceptional returns. While the S&P 500 lost money, Eveillard's overseas fund gained 5.7 percent, 5.4 percent, and 12.5 percent from 2000 to 2002, respectively. In 2008, however, Eveillard's magic could not avoid the trauma that afflicted just about every nook and cranny of the global market and lost 21.1 percent. However, it did beat the 37 percent loss recorded by the S&P 500.

This current recession has been, and will continue to be, brutal for some time. Because none of us can predict when it will bottom and when the stock market will recover, we need some exposure to the asset classes that will recover when this mess sorts itself out. Money market funds are not a safe haven. They earn almost nothing, and it's almost assured that investors will overstay this asset class and miss the biggest part of the eventual stock market recovery.

U.S. Treasuries are also iffy. Huge chunks of money have entered the Treasury market and as a result, Treasury yields are at historic lows. Short-term Treasuries now yield less than 1 percent. Have the speculators invaded this sacred turf?

So we need a few hiding places. Treasury Inflation Protected Securities pay a decent yield and they protect us from the almost inevitable inflation given the federal deficits. The high-yield bond funds have stabilized after the speculators exited that sector. Plus they pay handsome returns while we wait for the recovery. And Jean-Marie Eveillard's overseas stock fund gives us out-of-the-way exposure to any stock market recovery.

Ray Unger is chairman of Forward Investment Advisors in Madison. He can be reached at 833-9400.

Ray Unger  —  1/09/2009 4:00 pm