Rydex Investments hopes to move beyond market timers to mainstream advisors.
Bryce James, who designs asset allocation strategies
for institutional clients, disagrees with the way many financial
advisors allocate assets.
"The traditional stock-to-bond to cash split is nowhere close to the reality of how a portfolio should be deployed," says the president of Smart Portfolios in Seattle, Wash. "What metric says you should only put 5% of your money into noncorrelated investments?" James uses inverse rate funds, inverse index funds, commodity-linked funds, leveraged funds and other products to design strategies that often place greater emphasis on nontraditional investments than conventional asset allocation models.
Like flat-screen televisions or online dating services, investment strategies once considered radical are now moving toward the status quo as the financial services business pumps out a growing roster of hedge-like mutual funds, investments linked to commodities and currencies, long/short funds, and other once-exotic vehicles. Rydex Investments, a firm that specializes in such "off the beaten path" products, is capitalizing on the growing demand for alternative investments by expanding the niche it developed more than 12 years ago.
"They were the first to take the road less traveled," says James of the firm. "When most of Wall Street was busy introducing 'me too' stuff, they didn't go with the status quo."
Founded in 1993 by the late Skip Viragh in borrowed office space and with two employees, the Rockville, Md., firm was the first fund company to use leverage for equity and bond funds, and the first to offer inverse fixed-income and inverse equity funds. Today, it manages approximately $13 billion in 51 mutual funds, including two ETFs and a fund of hedge funds.
While some of those products are designed to enhance or amplify returns in a bull market, the major draw over the last several years has been in noncorrelated investments that can be used for hedging traditional stock and bond portfolios, says Rydex chief executive officer Carl Verboncoeur, who assumed his position in 2003 after Viragh stepped down for health reasons. These include several inverse index funds, an inverse bond fund, and both closed-end and open-end mutual funds that employ hedging strategies.
"We've always had a niche among advisors, and with the increasing popularity of alternative investments we have the opportunity to expand that niche," says Verboncoeur. "A sideways market that could be around for the foreseeable future has created a tailwind for us."
The question now is whether the firm can get on the radar screens of more mainstream advisors than it has in the past. With its liberal redemption policies and sophisticated fund lineup, many of those drawn to the fund complex's offerings early in its history have been market timers who traded in and out of mutual funds as a major part of their strategies. Now, that's changing. "Our shareholder base has evolved, particularly over the last three or four years," says Verboncoeur. "Today, we're seeing more strategic advisors who combine buy and hold with tactical asset allocation and alternative investing." These advisors are attractive to Rydex because they represent stickier assets that won't vanish regularly into a third-party platform provider's money market fund or whip through funds faster than a Kansas tornado.
The shift comes as the firm looks back on net outflows of $740 million for 2005, according to Financial Research Corporation in Boston. Much of the bleed came from inverse bond fund Rydex Juno, which posted negative returns last year as long bond rates unexpectedly held their ground. By comparison, Rydex had net inflows of $3.7 billion for all of 2004 and $2.7 billion in 2003.
The "tactical" asset allocators the firm is courting these days do not necessarily fit the classic market-timer mold. Some use alternative investments as a sleeve component of their portfolios that accounts for only 10% or 20% of assets. Others may use a traditional buy-and-hold approach, but reserve a portion of their portfolios for more active investing designed to capitalize on short-term market conditions.
Rick Gage of Strategic Equity Management in Scottsdale, Ariz., uses Rydex funds for core and satellite strategies. He combines 70% to 80% of a passive core portfolio, consisting of traditional stock and bond asset classes, with a 20% to 30% mix of active satellite investments. The satellite part of the portfolios often includes hedges or noncorrelated investments. Gage says the approach is designed to help smooth out returns and keep clients comfortable with an investment plan over the long run. "A hedged portfolio may not keep up in a strong bull market," he admits. "But I've found that if you lose less in down periods, it adds a comfort factor."
According to a recent study from Rydex affiliate AdvisorBenchmarking, the number of tactical advisors like Gage is growing. Nearly 16% of advisors surveyed said they had "become more tactical asset allocators" in 2004, compared with 7.3% who made such a transition in 2003. Overall, 40% of advisors surveyed described their investment style as "tactical." Most said they still created long-term strategic asset allocation targets, but combined them with periodic adjustments for the asset mix based on short-term market adjustments.
Despite the reported shift in attitude, the road to carving a bigger niche in the advisor market may not be smooth. Many advisors continue to rely on traditional asset allocation models, and some question the effectiveness of more aggressive techniques such as the use of leverage to magnify returns, inverse investments, frequent trading and short-selling.
"We're not a trading firm and we don't make active bets," says Rick Ferri of Portfolio Solutions, whose Troy, Mich.-based firm manages $600 million in assets. "We put together long-term, long-only portfolios and rebalance them once a year." Ferri, who uses passive investment strategies that he implements with index funds and exchange-traded funds, feels that fund firms often overstate the usefulness of noncorrelated investments to promote sales.
Even advisors who are open to the idea of expanding their alternative investment horizons may already be doing so through well-known funds such as Baron Partners and Leuthold Core Investment Fund, which have the authority to hedge against market fluctuations. As of September 30, the mutual funds tracked by Morningstar that use hedge fund strategies managed $12.7 billion, up from $4.6 billion two years ago, and more fund companies plan to introduce offerings with similar strategies.
Rydex also faces competitive challenges from ProFunds and Potomac, two smaller players in the alternative-investment mutual funds space. In August, ProFund Advisors signaled its intention to enter the exchange-traded funds business by hiring Gus Fleites as chief investment officer and head of ETFs. Fleites, formerly a senior principal of State Street Global Advisors, was previously president of SSgA's streetTRACKS family of ETFs. Chairman and CEO Michael Sapir says he can't discuss anything currently in registration, except to say that his firm "intends to offer products that will fill needed spaces."
Meanwhile, Potomac reports strong interest in such offerings as the Commodity Bull Fund, which invests in commodity-linked derivative instruments. Like Rydex, however, both ProFunds and Potomac have seen net outflows in 2005, according to FRC.
A new campaign designed to get advisors to take a second look at the way they allocate assets may help Rydex distinguish itself in an increasingly crowded field. In October, the firm announced the introduction of Essential Portfolio Theory, an investment approach that, according to the firm, is designed "to help investment advisors, brokers and investors understand the dynamic nature of modern markets and learn how to potentially increase portfolio diversification and manage risk." Among other things, EPT advocates "expanding traditional stock/bond/cash asset allocation to include asset classes with positive and negative correlation to the market, such as commodities, futures, real estate, inverse investments, hedge funds and leveraged or currency products."
It is also increasing emphasis on packaged products aimed at advisors who want to use tactical asset allocation and alternative investments but don't want to devote the time necessary to monitor such strategies. These include two open-end hedged funds launched in the fall, the Rydex Absolute Return Strategies Fund and the Rydex Hedged Equity Fund. The Rydex Absolute Return Strategies Fund, benchmarked to returns of the broad hedge fund industry, invests in stocks, bonds, commodities, currencies and options. It also uses market-neutral, merger arbitrage and fixed-income, duration-neutral strategies. The Rydex Hedged Equity Fund, designed to mimic returns of long/short funds, invests in equities and options and uses market-neutral and merger arbitrage strategies. The new offerings join Rydex SPhinX Fund, a closed-end hedged fund-of-funds that equally allocates assets across 41 different hedge fund managers.