‘Alternative’ Investing Gains More Appeal

Stock and bond mutual fund investors mostly enjoyed another winning quarter in the first three months of this year, as equity markets extended the advance that began a year ago and as interest rates stayed under control.

But many U.S. investors may notice that their bread-and-butter stock holdings -- blue-chip issues -- scratched out only modest gains in the period. Technology shares also stalled.

The best-performing stock funds by far were foreign portfolios, particularly in Asia and in emerging markets such as Mexico, according to fund tracker Morningstar Inc. Also hot were some sector funds that focus on hard assets -- specifically, real estate and natural resources.

Some investment pros say the first quarter may reinforce the idea that the U.S. market could struggle to eke out gains in the years ahead, and that investors would be wise to look to so-called alternative assets for a chunk of their portfolios.

“Alternative” means different things to different financial advisors. But it primarily means investments that have a good chance of performing well over the long run, even if the average U.S. stock doesn’t.

Lou Stanasolovich, president of Pittsburgh-based Legend Financial Advisors, said he had increasingly turned to alternative funds in recent years for a portion of the $200 million he manages for clients. One of his picks is the Leuthold Core fund, based in Minneapolis.

Unlike conventional equity funds that keep most of their money in stocks at all times, the Leuthold Core fund stresses flexibility. It can own stocks, bonds and money market securities, and it also can “short” stocks -- that is, sell borrowed shares, betting that the price will drop.

In the first quarter Leuthold Core gained just 1.5%, lagging behind the 3% return of the average U.S. stock fund. But over the last three years the Leuthold fund generated an average annual return of 9.1%, compared with 2.7% for the average stock fund, according to Morningstar.

Leuthold Core’s managers were able to limit the fund’s losses in the bear market of 2000 through 2002, and that is a big part of what Stanasolovich looks for in an alternative fund, he said.

With investing, “If you don’t lose big, you don’t have to win big” later to make it up, he said.

Financial advisors who are worried about the U.S. stock market’s longer-term prospects typically didn’t just shift to that view in the last two months, as prices pulled back. After last year’s hefty gains, even many optimistic Wall Street pros were saying that U.S. share prices, relative to underlying corporate earnings, were at high levels historically.

Sheldon Jacobs, editor of the No-Load Fund Investor newsletter in Ardsley, N.Y., thinks the market rally could extend into 2005 if the economy’s recovery continues. But with the average blue-chip stock selling at about 20 times this year’s estimated earnings per share, Jacobs said a sharp jump in prices in 2004 probably would just hasten the onset of another bear market in 2005.

Obstacles Ahead

Even if the economy improves, U.S. stocks face a number of obstacles in the years ahead, many experts say: the threat of higher interest rates and inflation, the nation’s huge trade and budget deficits (which make the economy more dependent on foreign investors), and the risk of more terrorist attacks.

“It’s very easy to envision the economy sliding back or the Federal Reserve raising rates,” said Russ Kinnel, director of fund analysis at Morningstar in Chicago. Either event could be devastating for the market, he said.

Given the risks, Kinnel said, “I would want to have a little money with managers who are more flexible” than the typical stock fund.

Many of those kinds of funds are in the categories Morningstar calls “allocation” funds, as in asset allocation. Leuthold Core, for example, is in the “moderate allocation” category, meaning funds that tilt more toward stocks than other assets (as opposed to “conservative allocation” funds, which tilt more toward bonds).

Another moderate-allocation fund is the Los Angeles-based FPA Crescent fund, part of the First Pacific Advisors fund family. Manager Steve Romick is sour on most U.S. stock sectors today because he thinks share prices are too high. But he likes some energy issues, particularly in the natural gas industry.

“We’re big believers [in energy] over the next five to 10 years, as a macro play,” he said, because of expectations of strong demand and limited supplies.

The Crescent fund was up 4.4% in the first quarter and gained an average of 19.7% a year over the last three years.

Bolstered by high oil prices, funds that focus exclusively on natural resources stocks jumped 6.7% in the first quarter, on average.

Shares of many other commodity-related companies also have performed well over the last year, as prices of basic materials such as copper, nickel and steel have soared, fueled in part by robust demand from China’s booming economy.

Commodities, and other hard assets, appeal to many investors who are worried that higher inflation is bound to follow if the economy continues to gain steam. Hard assets historically have provided a hedge against inflation.

But apart from natural resources funds, which are heavily invested in energy, relatively few mutual funds try to bet exclusively on commodities.

Ken Heebner, Boston-based manager of the CGM Mutual and CGM Realty funds, has owned shares of a number of commodity companies in the last year, including copper giant Phelps Dodge.

He said he expected the supply-demand imbalance in many commodities to help push prices higher into 2005. “I’m hoping for another year” of strong performance from the stocks, he said.

Short-Term Strategy

But eventually with most commodities, supply catches up with demand, and prices suffer, Heebner said. So he tends not to think of them as long-term investments.

Many investors who worry about inflation and geopolitical risks also have turned to gold over the last two years. Gold reached a 15-year high of nearly $428 an ounce last week. But a pullback in gold prices in January and February hurt gold mining stocks and the mutual funds that owned them in the first quarter: Precious metals funds lost 1.3% in the period, on average, after soaring 59% last year.

Investors who like the idea of using funds that focus on natural resources, other commodities or gold as pieces of an alternative portfolio should realize that those sectors can require more specialized knowledge, Jacobs said.

“If you understand the supply-demand dynamics you can make money in gold,” he said. “That’s true of so many of these alternative categories -- you really have to understand them.”

Or, you have to trust that the fund manager you’re investing with truly understands them.

Another potential challenge to many fund sectors that are considered more alternative than mainstream is that they have already had terrific performance runs in recent years.

In other words, if you’re trying to buy what has lagged rather than what has led the market, the numbers wouldn’t lead you to gold, real estate or natural resources funds.

The average precious metals fund is up 22.2% a year over the last five years, according to Morningstar. In the same period the average U.S. stock fund is up 3.1%.

Real estate-related funds, which mostly own real estate investment trust shares, zoomed 11.9% in the first quarter, and were up 17.7% a year over the last five years through March 31. But some investors may be growing wary: Many real estate stocks have dived over the last few sessions as worries about higher interest rates have revived on Wall Street.

Many fund managers who have more flexibility with their portfolios say the best alternative assets today may be foreign stocks rather than hard-asset stocks, Kinnel said.

“I’ve heard from managers across a large spectrum of funds saying they don’t find a lot that’s attractive, except in overseas markets,” he said.

Not So Fast

Yet some financial advisors say the downbeat sentiment toward U.S. stocks may be premature.

Dan Sullivan, editor of the Chartist investment newsletter in Seal Beach, said he was sticking with his U.S. fund recommendations, including portfolios such as the Ariel Appreciation and Pin Oak Aggressive funds.

“We’re saying let it run,” he said. “The average bull market lasts 2 1/2 years. So I think we still have a ways to go.”

While bigger U.S. stocks have lagged, many investors continue to find issues they like among smaller companies. The U.S. small-capitalization “value” fund sector gained 6% in the first quarter, continuing the strong run of the last few years.

Some analysts warn that investors could outsmart themselves by trying to construct a portfolio that is skewed too far away from the U.S. market.

Kinnel, for example, said he wouldn’t advise that investors simply give up on funds that own large-capitalization U.S. stocks. Because they’ve been among the poorest performers, relatively speaking, over the last five years, one could argue that they’ve got more rebound potential than many other sectors, he said.

That doesn’t impress advisors like Stanasolovich, though. Given how well U.S. stocks have done over the last 20 years, he thinks investors should be prepared for a long period of sub-par returns. And the way to be prepared, he argues, is to have a significant amount of money in market sectors that may zig if U.S. stocks zag -- or to invest with managers who can do the work for you.

At FPA Crescent fund, manager Romick said the best strategy right now may be to wait. He has about 30% of the fund’s $500 million in assets in cash.

“As we survey the landscape we can’t find an asset class that’s out of favor,” he said. That’s highly unusual, and it’s the best reason to be cautious, he said.

Healthy long-term returns in any market, Romick said, depend on “being smart enough not to commit capital unless the risk-reward ratio is favorable from the get-go.”