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Director of portfolio strategy, Rydex Investments
Before joining Rockville, Md.-based Rydex Investments in 2004, David Reilly was a senior vice president of research at LPL Financial Services and a director of institutional marketing and communications at State Street Research. Reilly, a CFA, began his career at Scudder, Stevens and Clark. He recently spoke with writer Judith Schoolman.
Q: How should investors approach asset allocation in light of what happened in the markets in 2008?
A: Differently. What the industry has done in the past decades is simply divide among stocks, cash and bonds. For too long, investments revolved around these three. But given the problems in 2008, this doesn't give a portfolio diversification. If you get into a meltdown, these allocations move down together. Stocks go up in bull markets, but there are long periods when they don't do much. The response has been to make offsetting allocations to bonds, which have been a steady source of return—a lower source of return historically, but less volatile. Cash is thrown in there, too. But these types of asset allocations are not so good over time.
Q: What kind of investors should use alternatives and what types of alternatives are appropriate for the retail investor?
A: If you take a look at alternatives, you come away with the realization that they are more useful for retail/conservative investors than they are for high-net-worth investors and institutions. Why? You see good returns over time, relatively low return volatility and correlations that are low or negative.
Alternatives come in two major classes. One is any return-generating asset that's not a stock, bond or cash instrument. So, we're talking about a commodity, currency or real asset such as real estate or anything tangible. The second is an investment strategy that seeks to do anything other than outperform an index. This type of alternative typically will go down less than an index will.
Q: Inverse funds are growing in popularity now. Are they a good way to hedge?
A: Yes. Think about traditional ways investors have had to hedge equity risk. If you think markets are going to be nasty,first you can raise a lot of cash, but that has problems. Other ways to hedge equity risk are to pare back on equity, increase your bonds, or do stuff internally to lighten up on small- and mid-cap exposure. Also, be less [invested] in emerging markets, less international and get more defensive.
In 1994, along came inverse funds, a very direct way to address equity-market risk head on. Funds, options, short-stock baskets—they react inversely on a day-to-day basis. If the index goes down 2%, the fund goes up by the same amount. Fees tend to be close to those of garden-variety mutual funds, so they are very cost-effective and very efficient.
Q: What is your best advice to investors in 2009 and how much volatility do you expect to see this year?
A: We're near the bottom in stocks, but volatility will continue to be a fact of life. You don't have to start over. You can embrace your portfolio. Look at the 60/40 portfolio. If you make an allocation of 20% to 25% in alternatives, there can be a big improvement in the portfolio's ability to control volatility in the stock market. What you own is still there and you can add to the portfolio. It's essential to do that. The market has proved that the buy-and-hold technique is not an effective way to go.
People are critical of alternatives, but there have been things that worked very well, such as currency exposure. The dollar/yen did well. Noncorrelating asset portfolios, such as managed futures, did very well in this period because of their ability to short things other than stocks.
Q: So what do you recommend?
A: Use down markets as a profit source. Take price momentum, inverse strategies and managed futures—and add to the three asset classes of stocks, bonds and cash—and you'll end up having 11 or 12 attractive characteristics with positive returns over time, low volatility and low correlation.
