A trader works in front of a board displaying the chart of German share index DAX at the stock exchange in Frankfurt/M., western Germany, on November 2, 2011.DANIEL ROLAND/AFP / Getty Images
In financial markets where the greatest risk is not earnings or interest rates but confidence itself, investors can be forgiven for feeling nervous. Hope springs eternal, but right now the lust for gains is being countered by fear.
Take the bond market. Italian bond yields broke through bailout territory of 7 per cent this week, but few were stepping up to buy. They'd rather buy German bonds or U.S. Treasuries yielding less than 2 per cent, as if inflation will remain subsumed and interest rates low for the next 10 or 20 years.
The stock market, too, is nervous. Investors can pick up some alluring yields on good quality North American stocks, and many are doing so. But would that 5 per cent dividend yield be as comforting if the stock price lost a third or more of its value? It's a deflating prospect.
In financial markets, confidence is everything. Christine Lagarde, head of the International Monetary Fund, warned this week that the world risked a "downward spiral of uncertainty, financial instability and potential collapse of global demand." So what is an investor to do?
If you're a high-net-worth investor, the choices are manifold, especially in the alternative investment field. You can partake in some excellent long-short equity strategies that are closed to people of more modest means.
If bonds are your cup of tea, you can participate in the long-short bond strategies devised by fixed-income manager Barry Allen, founder of Marret Asset Management Inc.
"In a real crisis, bonds will make money and stocks will lose," says Mr. Allen.
For accredited investors (read wealthy), the firm offers the Marret High Yield Hedge LP, and for retail investors, the Marret High Yield Strategies Fund and the Marret Investment Grade Bond Fund, both closed-ended funds that trade like stocks on the Toronto Stock Exchange. The high-yield fund has a current tax-advantaged distribution of 8 per cent a year; the investment grade fund has 5 per cent.
"We're in a unique period in financial markets," Mr. Allen says. Not only is the world awash in debt, the debt is concentrated in governments. Governments can either pay down their debts or they can default, he explains.
While financial markets have plenty of experience with corporate restructurings, "there is really no precedent as to how to restructure a major Western sovereign country," Mr. Allen says. "That's why there is so much uncertainty and volatility in markets."
Another problem is that markets are increasingly moving in the same direction at the same time. "Because correlations are rising so dramatically, it's more difficult to diversify," Mr. Allen says.
Portfolio managers are trained to look to past economic circumstances to see which investments did well during certain periods, but "in an environment that's unique, you can't do that."
While September was a bad month for hedge funds generally, it was even worse for major stock indexes. The Scotia Capital Hedge Fund Performance Index (asset-weighted) was down 1.82 per cent for the year to September 30, while the equal-weighted version of the index was down 8.86 per cent.
The S&P/TSX composite index fared even worse, falling 13.53 per cent in the year to September 30, while the Standard & Poor's 500 composite index fell 10.04 per cent in U.S. dollars.
Bonds, meanwhile, behaved like they are supposed to, moving the other way. The DEX Universe Bond Index was up 7.45 per cent for the year to Sept. 30.
Mr. Allen thinks there's a "reasonable probability" that Europe's sovereign debt problems will spread to North America.
What he likes most now is long-duration bonds of triple-A rated U.S. multinationals – companies like Procter & Gamble Co., Johnson & Johnson Inc., McDonald's Corp. and Microsoft Corp. "It's also prudent to have some exposure to precious metals," he says.
Against these long corporate bonds, he has sold short U.S. Treasurys, whose prices have been pushed up by the Federal Reserve. By buying corporate and selling Treasurys, he isolates the credit spread – the difference in yield between the two types of bond.
High-net-worth investors seeking relatively safe entry to the stock market are taking note of newcomer Waratah Advisors of Toronto, a long-short equity fund launched in January 2010 by Brad Dunkley, a former portfolio manager at Gluskin Sheff + Associates, and Blair Levinsky, a former managing director at TD Newcrest. Like Marret, Waratah follows the classic hedge fund model rather than borrowing to make big unhedged bets.
The Waratah Performance Fund is up 28 per cent over the past 15 months, Mr. Levinsky says. Even in September, a brutal month for stock markets and many hedge funds, the fund was down only 0.4 per cent. Its goal is to make compound annual net returns of 15 per cent over five and 20-year investment periods.
"We don't like losing money," Mr. Levinsky says. "Our primary emphasis is on protection of capital." Like Marret, the Waratah portfolio managers are big investors in their own funds. Mr. Dunkley has a long and successful track record at Gluskin Sheff, where he launched the money manager's long-short strategies. By protecting capital in down markets, the Waratah partners hang onto their gains so "there's not a lot of risk of having to climb out of a hole," Mr. Levinsky says.
Waratah's objective is straightforward: "We want to be able to produce market returns or greater with much less exposure to the market than a long-only manager," he says. Again, the highest possible return with the lowest possible risk. As well as selling short, the managers will pull money out of the market when it "gets ugly," then gradually move back in when it stabilizes, a process Mr. Levinsky likens to expanding and contracting, or breathing in and breathing out.