The hedge fund portfolio is composed of mutual funds that generally have low correlations with the stock indexes and also with each other. The result is a portfolio that rarely suffers a significant short-term loss and that can hold its value or even appreciate when the major indexes are declining. In the quarter ended June 30, the portfolio basically was stable while the S&P 500 suffered through the quarter. Over the last year the portfolio also held steady while the S&P 500 declined by over 12%. The portfolio has earned more than the index over longer periods. The portfolio will lag the index during a bull market but hold its own or do better at other times. One way to measure an investment's correlation with the index is a statistic called beta. A beta of 1.0 means the investment rises and falls in line with the index. A beta of 0.0 means there is no relationship between the investment and the index, and a beta of less than zero is a negative correlation between the two. This portfolio has a beta to the S&P 500 of 0.32 for three years. At times it is lower. The portfolio also has less than half the volatility of the index, making a smoother ride for investors. Since the funds in the portfolio are not highly correlated with each other, most of the time some funds are doing well while others are not. Two recent standouts in the portfolio are a pair of value-oriented balanced funds: Oakmark Equity & Income and FPA Crescent. Each is a bit unconventional for a balanced fund. The fund managers have been rather pessimistic about economic and financial prospects since the credit and mortgage crises began in the summer of 2007. FPA Crescent recently had about 40% of its portfolio in cash and sold short some financial stocks. It also buys small company value stocks and high yield bonds, instead of the straight bonds and big company stocks of most balanced funds. Oakmark Equity & Income's managers have been worried about inflation. Treasury bond holdings have been either short-term or inflation-protected securities. It generally has avoided mortgages and high yield bonds. The stocks tend to be smaller and more cash-rich than other balanced funds. Its top stock holdings recently were energy firms. A diverse group of funds were the bottom performers for the second quarter. Cohen & Steers Realty Shares has been suffering with the bear market in real estate investment trusts for the last 18 months or so. It still has stellar longer-term returns and probably is near a low point. But it won't generate strong returns until the economy looks healthier. Third Avenue Value is a deep value investor that buys many types of securities. It typically has part of its portfolio in distressed or bankrupt companies. It bought into some mortgage bond insurers and other financial firms early in the financial crisis. Manager Martin Whitman believes there is a sufficient margin of safety for the fund to profit from these positions, but so far the markets have moved against him. Wintergreen Fund has had a rough 2008 after market-beating years in 2006 and 2007. It made some good recent moves by raising cash and selling short Blackstone Group. But it also has large exposures to Japan and to other Asian markets that fared poorly so far this year. This is another deep value fund, and it can invest anywhere in the world. A fund that profited from the declining dollar for several years, American Century International Bond, finally lost some ground recently as the dollar staged a recovery. We don't know if the dollar will continue its recent appreciation or not, and we don't try to forecast such moves in this portfolio. We hold the fund to earn profits when the dollar is falling, so that its gains will offset likely losses in other investments. Hussman Strategic Growth and PIMCO All Asset have some similarities. Each uses primarily quantitative models to determine how the fund is allocated among different assets. Hussman generally owns a portfolio of stocks that it either hedges or leverages with options. The fund has been fully hedged for most of the last couple of years. PIMCO All Asset allocates its portfolio among almost any of the funds offered by the PIMCO fund complex. Recently the fund was invested primarily in inflation hedges, emerging market stocks, and some conservative bonds. It owns virtually no U.S. or European stocks. Schwab Hedged Equity both purchases and sells short stocks. It uses stock rankings developed by Charles Schwab & Co. from which to draw the list of investments. Through its short life the fund consistently has underperformed the S&P 500 in bull markets and beat the index in most falling and choppy markets. Even so, it has not performed as well as I expected in the downturn, and I am considering a replacement. T. Rowe Price High Yield obviously invests in high yield bonds. It does a better job than most of its competitors. It might have a tough time if the economy remains weak and defaults on high yield bonds increase. But it has a cash cushion of almost 7% and a record of earning higher returns with less risk than other high yield bond funds. It provides a nice balance for other positions in the portfolio. Berwyn Income also invests in the high yield market but with a more aggressive strategy. The portfolio was constructed to provide a relatively smooth ride over time. It is a buy-and-hold portfolio. We make changes only when there is a major change at a fund or a better complement to the rest of the portfolio is located. The portfolio can substitute for any of the Core Portfolios or be the entire portfolio of someone who wants to minimize the time spent managing investments. September 2008.
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