The Big Picture for the Week of June 6, 2010

Credit Writedowns hosted a guest post by Frederick Sheehan titled Should Investors Boycott The Stock Market? Candidly the article didn't really focus on that question but it is interesting nonetheless. More interesting perhaps could be to wonder if investors should boycott volatility?

On the Seeking Alpha version of my Put Write post the other day Geoffrey Lordi mentioned the Merger Fund (MERFX). I wrote about this fund in a little bit of detail not quite four years ago. The fund chugs along doing its own thing regardless of what else is going on the (stock market) world. In the last ten years as the S&P 500 has had a wild ride on the way to a 30% decline the Merger Fund has had a much smoother ride to unchanged. Unchanged for a decade may not seem so hot but in a down 30% world I think it is pretty good. The strategy of merger arbitrage lends itself to a smoother ride. While I do not know how good the people running MERFX are I can say that over a similar period of time (the beginning of the chart for ten years did not look right so moved it in a little) the Arbitrage Fund (ARBFX) has had a much better result and also a very smooth ride.

There are other funds and strategies that that accomplish similar results, I've written about quite a few of them over the years. To the extent this site does share process these types of funds help with managing portfolio volatility which is a very important concept. If you've been reading this site for a while you know I am big on reducing volatility at certain times (mostly by using ProShares Ultra Short S&P 500 (SDS)) and I believe now is one of those times and so we have a position on in SDS.

Buying an inverse ETF is more akin to temporarily dampening volatility whereas a portfolio full of different products that try to do the same thing as MERFX or ARBFX would be shunning volatility altogether. Something like a permanent portfolio (25% gold, 25% stocks, 25%long bonds and 25% cash) or Nassim Taleb's portfolio and similarly Zvi Bodie's portfolio (80-90% in things like t-bills or TIPS and the rest seeking a lot of volatility) would be somewhere in between the extremes.

At the very least these sorts of things have intellectual appeal. For anyone interested in doing this, and as declines scare more people more people will consider shunning volatility, there are two practical concerns to address. Not every fund will work as it is supposed to. During late 2008 there were all sorts of funds (and accompanying articles) that went down a lot despite targeting absolute returns, hedging strategies or both (a search for headlines for Schwab Hedged Equity SWHEX will probably lead you to some articles) ended up looking a lot more like the stock market than they "should have."

I would warn that just because a fund "worked" the last time doesn't mean it will work the next time. Rules about not making any large bets certainly applies in this space, same as equities.

The other big concern that comes to mind right away is more behavioral. The emotion that leads a person to chuck the equity market is very likely to create impatience after a massive rally. Pretend for a moment that we are currently in the middle of the scare the hell out them decline I have been writing about; I am positive there are people who sold near the low, realized how much they missed so bought back in close to the top and are currently freaking out poised for more ruinous behavior. While that certainly is an extreme example, there are plenty of people who get impatient and to the extent investing requires patience you can see the point I'm making.

In my opinion the answer is better asset allocation. A few times in the last couple of years I've commented about people learning the hard way they had too much equity exposure. Hopefully it is obvious that in this conversation something has to give. The more equity exposure the more volatility and with less equity exposure comes the need to save more money. So I think the solution for people in this camp is a higher savings rate, innovative thinking with regard to asset allocation and time spent learning about various investment products. Obviously several of the ETF providers have created product for this space and if the demand increases there will be more of them to come and while some may not be helpful many will be.

You probably know that John Wooden passed away last night. What a truly amazing man he was.