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Many investors need and want the growth potential of stocks, and these investors tend to have a substantial allocation to stock funds. But not all investors want to take stock market-level risk. Although bonds are less volatile than stocks, many investors are also concerned about owning solely bonds, particularly given the possibility of higher interest rates. But there is a middle ground between funds that are entirely invested in stocks and funds that are entirely invested in bonds.
Balanced funds are a common solution for conservative investors. These funds invest in stocks for growth and bonds for income and may serve as a buffer against volatility. The classic balanced fund tends to invest in U.S. stocks and bonds, allocating 60% to large-cap stocks and 40% to higher-quality bonds, but there are many variations of balanced funds to consider. Some balanced funds allocate more to stocks, while others have more exposure to bonds. There are balanced funds that invest in small- and mid-cap stocks and those that invest in lower-quality bonds. Some balanced funds focus on domestic stocks and bonds, and some seek opportunities around the globe.
Balanced funds with more exposure to stocks are designed to do better when stock markets are rising, while funds with more exposure to bonds are designed to do better when stock markets are volatile. But what happens if both stock and bond markets decline? That’s where alternative funds come in.
Alternative is a broad category that includes both riskier and more conservative funds. The more conservative alternative funds aim to provide lower-than-market volatility. Rather than relying solely on bonds to cushion volatility, these alternative funds may use options, arbitrage or alternative assets (such as real estate or precious metals) as a hedge. Because alternative funds typically have less exposure to bonds, these funds often have less interest-rate or credit risk.
These funds often employ complex strategies (often used by hedge funds), like long-short strategies. Most stock funds “go long” on stocks by betting that a stock’s share price will rise. But funds can also bet that a stock’s price will decline by “shorting” a stock. Long-short funds include both long positions on stocks that the manager expects will go up, and short positions on stocks they expect to go down. The short positions are intended to act as a hedge against the long positions and because of this, long-short funds may have lower volatility than the overall stock market.
Alternative funds also may use merger/arbitrage strategies, which attempt to take advantage of short-term pricing discrepancies. A fund that focuses on merging companies might seek to arbitrage the spread between the price of a company being acquired and the company that is doing the buying. The fund will go long on the target company and sell short the acquirer’s stock. Because arbitrage funds are both long and short, they are typically less volatile than a long equity fund.
The challenge for conservative investors is often how to decide which balanced and alternative funds to own now and when to move their portfolios to different funds. The Upgrader Funds do it for you, and these three funds have exposure to balanced and alternative funds.
Flexible Total Return Fund (TOTLX)
TOTLX can invest in total return funds, which include balanced and alternative funds, as well as bond funds. It seeks to own funds that are excelling in the current market environment. As of June 30, 2015, nearly half of the Fund’s portfolio was invested in total return funds, such as balanced and alternative funds.
Flexible Income Fund (INCMX)
INCMX is primarily invested in bond funds. It may have limited exposure to total return funds, such as balanced funds and alternative funds. As of June 30, 2015, it had about 22% devoted to these funds.
Conservative Upgrader Fund (RELAX)
RELAX is a balanced fund-of-funds: it holds both core diversified stock funds as well as bond funds. It also typically has some exposure to balanced and alternative funds that have had strong recent returns. As of June 30, 2015, it had about 10% in these funds.
Stocks are generally perceived to have more financial risk than bonds in that bond holders have a claim on firm operations or assets that is senior to that of equity holders. In addition, stock prices are generally more volatile than bond prices. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. A stock may trade with more or less liquidity than a bond depending on the number of shares and bonds outstanding, the size of the company, and the demand for the securities. Similarly, the transaction costs involved in trading a stock may be more or less than a particular bond depending on the factors mentioned above and whether the stock or bond trades upon an exchange. Depending on the entity issuing the bond, it may or may or may not afford additional protections to the investor, such as a guarantee of return of principal by a government or bond insurance company. There is typically no guarantee of any kind associated
with the purchase of an individual stock. Bonds are often owned by individuals interested in current income while stocks are generally owned by individuals seeking price appreciation with income a secondary concern. The tax treatment of returns of bonds and stocks also differs given differential tax treatment of income versus capital gain.