"Alternative" Investments to Survive This Economic Storm

Most investors buy stocks for growth and bonds to provide income and ballast for their portfolios. And that's about it. Rob Arnott thinks such a limited approach will result in wretched -- not to mention volatile -- returns in the coming years. "It's too narrow a focus," he says. "You need a bigger toolkit."

That’s because of what Arnott calls “the 3D hurricane:” deficits, debt and demographics. “Look at the headwinds coming the way of the developed world,” he warns. “And the U.S., in some ways, is at the center of the storm. I worry terribly about the economy and about how most people are invested. This is a time to be very defensive.”

Jarringly big annual budget deficits and a growing mound of outstanding debt are hardly new news. But Arnott says the debt problem is even more serious than it seems on the surface. What’s more, things are just about as bad in Western Europe and Japan. He says that the five leading developed countries -- the U.S., Japan, Germany, the United Kingdom and France -- account for only 40% of global gross domestic product but 70% of global debt. Stocks from emerging markets, which Arnott likes, account for the same percentage of GDP but just 10% of debt.

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In terms of demographics, just one new person is entering the workforce in the U.S. for every person who is retiring. Workers will be unable to support retirees with generous federal programs, Arnott says. Either entitlements such as Social Security, Medicare and Medicaid will have to be slashed, taxes will have to rise -- or both.

The demographic time bombs in Western Europe and Japan are far worse than ours because the U.S. receives many more immigrants.

Given these headwinds, Arnott says, the U.S. and the rest of the developed world will inevitably have to break the promises they have made to various parties. In some cases -- Greece being example number one -- governments will break their promises to bondholders by defaulting on their debt. In others, such as the U.S., the “solution” will be inflation and a falling dollar, which will cripple stocks and, especially, bonds.

Arnott’s Pimco Funds

What do you need to survive the storm? Arnott’s toolkit includes emerging-markets stocks and bonds; real estate investment trusts; Treasury inflation-protected securities; commodities; high-yield (or junk) bonds; a long-short fund (one that owns stocks the old-fashioned way but also makes bets that other stocks will decline); and bond funds that can bet on interest rates to rise.

Arnott manages two funds: Pimco All Asset D (symbol PASDX) and the more venturesome Pimco All Asset All Authority (PAUDX). These funds aren’t intended to be the center of most portfolios. Rather they’re designed to augment a more traditional allocation.

Arnott, 56, and his associates use computer models, which they’re constantly tweaking, to help them decide how much to assign to the various asset categories. They meet with Pimco honchos at least once a month to make certain Arnott’s allocations are as effective and up-to-date as they can be. Arnott’s funds invest entirely in other Pimco funds, although his firm is independent from Pimco.

All Asset recently had 9% of its holdings in stocks, 7% in short-term bonds, 11% in investment-grade bonds, 6% in emerging-markets bonds, 15% in junk bonds, 10% in TIPs, 16% in a long-short fund, 7% in commodities, 4% in convertible securities, 2% in REITs and 2% in foreign bonds. It also had 11% in a bond fund that can bet on rising rates.

All Authority had roughly the same allocations, except that it was 13% short stocks -- in other words, in funds that that will rise if stocks fall. All Authority uses borrowed money to leverage its bets as well as to wager on declining stock prices.

Returns for both funds have been solid. From All Asset’s inception at the end of April 2003 through May 17, the fund returned an annualized 7.6% -- an average of 0.7 percentage point per year better than Standard & Poor’s 500-stock index. All Authority, which started at the end of July 2005, has returned an annualized 6.6%, an average of 3.2 points per year more than the S&P 500. Each fund is about one-third less volatile than the S&P index.

I think one of these funds makes sense for investors who stick to conventional stocks and bonds. I’d probably choose the more conservative All Asset. Its annual expenses are 1.27% a year. The expense ratio for All Authority is 1.38%. In both cases, the expense figures include the costs of the underlying Pimco funds.

But most investors, I think, probably have a lot of Arnott’s bases already covered. Emerging-markets stocks and bonds, junk bonds, TIPs, REITs and short-term bond funds are hardly exotic categories. Nor are commodities and commodity stocks.

I’m not a big believer in long-short funds. I think it’s hard enough for a fund manager to pick good stocks expected to rise in value, much less do so at the same time he is shorting stocks that he hopes will decline.

Don’t get me wrong; these are good funds. I just think a thoughtful investor can do without them. But for an investor who prefers to “outsource” investments in alternative assets, these funds are fine picks.

Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C. area.