What’s the typical strategy investors use to smooth returns? It’s balancing stocks with bonds. Mutual fund manager Stephen Hammers says that’s not the way to get optimal returns. He explains his multi-asset class, long-short methodology that’s proven to be less volatile than the stock market.

Kate Stalter: Today, our Daily Guru guest is Stephen Hammers. He’s the manager of the Compass EMP Alternative Strategies Fund (CAITX).

Stephen , why don’t you start out today by just giving us a little bit of background on the fund and on your objectives.

Stephen Hammers: Sure, I’d be happy to do that. The strategy of the Compass EMP Alternative Strategies Fund was actually created about 16 years ago. We actually decided to file in late 2008 for the Compass EMP funds, because these strategies were only available to very large institutions, typically with a minimum of $25 million to $50 million.

The objective of the portfolios, as well as the Alternative Strategies Fund, is a multi-asset structure with a lot of alternatives compared to traditional stocks and bonds.

One thing investors need to know is that you cannot diversify stocks away. It doesn’t matter if you have 50 stocks, 100, 500, 1,000, 5,000 or 20 stock funds. It’s one market, one asset, and you rise and fall with that market.

What the Alternative Strategies Fund helps provide is all the alternative asset classes that an investor or advisor needs to take care of all the downside hedging, and help a portfolio reduce their overall volatility, and help prevent what you went through in 2001 and 2002 and 2008, as well as what we’re getting into this year as well as our future.

The Alternative Strategies Fund is an 80% growth/20% income, moderately aggressive, basically hedge fund in the mutual-fund world. Daily liquidity, very low cost, anybody can invest in it and you can purchase it just about anywhere. The big key to this fund is, it is a rules-based asset allocation methodology, designed and has an objective of producing positive returns, regardless of the condition of the financial market.

It does mean that—every day, every month, and every quarter. Thankfully in years past, we’ve never had a down year, including 2008, where it was positive 11.8%, with our institutions, which is run the exact same way in the mutual fund now.

The big key here is a lot of liquid assets—very, very liquid, and we focus on correlation. We need some zigging and some zagging. Guess where you’d be? Right in the middle. So we have stock long-short, commodity long-short, managed futures, currency long-short, real estate hedge, and a global bond hedge.

So it doesn’t matter what happens in the future, whether markets go up. Many asset classes go up or down, including commodities, which fell with stocks in 2008. We have the ability to profit on both sides of the market and not just one side.

So to give an example, this year this fund is 70% less volatile than the stock market. Historically, it’s about 60% less volatile. It doesn’t mean that we restrict volatility; it just means that you have a lot of different asset classes, and they’re doing different things.

So it really doesn’t have a whole lot to do with the stock market, the bond market, or any market, because your goal is to hit base hits. If you try to go for a home run and say, “I’m going to put a lot of money in stocks, because I want a big return,” and all of a sudden it falls 50%, you have to make 100% to go back to where you were.

So our objective is to win by not losing, and give the investor alternative investments that big institutions have had for many, many years. That’s why they’ve been so successful; institutions like Yale, Harvard, and Vanderbilt have gone many years with their very successful returns. So this is now available to the average investor.

So the types of investments we have? Commodities, for example: Most investors want commodities for diversification. The problem with investing in a commodity mutual fund is that you’ll make money when it goes up, but you’ll lose money when it goes down.

So the investors thought in 2008 that they were diversified. Come to find out, that asset allocation didn’t work because everything fell together.

Our commodity long-short strategy was actually positive 40% in 2008 when the rest of the commodity market was minus 35%. Well how do you do that? It’s because when commodities start falling, and as long as the trend is confirmed and commodities are falling, we stop it and make it go the other way, which is exactly what allocation is supposed to do.

We’re actually shorting that, so we’re now making money when it goes down, too. So the types of commodities we buy, individual commodities. We don’t buy stocks, we don’t buy individual bonds. We get access to all these markets through futures, which are very, very liquid, and it gives us a better opportunity to make money on both sides.

So for example, we are long gold, long cattle, long sugar, long unleaded gas, but there’s assets like Brent crude oil, corn, wheat, cocoa, cotton, copper and aluminium—they’re short. So our commodity portfolio is a lot less volatile than other commodity portfolios, in the Alternative Strategies Fund.

It’s the same way with currency, same way with stocks, and same way with bonds. It’s a true hedge fund in the mutual-fund market.

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Kate Stalter: You know what struck me, Stephen, as you were talking? I interview a lot of advisors, and for a lot of those people, they’re very, very interested in smoothing out returns for their clients amid all the market volatility. But it sounds like that’s kind of inherent to your strategy, anyway, regardless of high degrees of volatility. Would that be the case?

Stephen Hammers: That is the case. We actually do better in high-volatility periods. I’ll give an example: In early August, when everybody was shocked when the S&P fell about 17% and international stocks fell about 20%, we were down 2%. We just cut volatility off at the knees.

Why were we down 2%? Because you have to give a chance for markets to fall to make sure this is real. We follow trends.

We don’t follow fundamentals, because fundamentals can lie. You can have good fundamentals, but the market can still fall. Companies have good fundamentals today, but the problem is the macro environment of the world.

There are too many problems in the world, and too much uncertainty. That’s why unemployment is still high. We have too many major, major debt problems that right now it’s very difficult to be resolved. So we just want access to the market, to the asset, and we don’t want to take risk in opinion risk, market risk, or asset risk.

So we take all of these alternative asset classes that I just mentioned, and we equally weight them all, in terms of the asset and the underlying commodity or currency, because we don’t want any opinion risk whatsoever, because we don’t want this to blow up. We want it to be smooth, consistent, base hits.

That’s what it’s about, and you cannot get that in stocks. You just can’t. Even if advisors or investors want lower volatility, the only way to get it is to add bonds. Then you’re going to reduce your return.

That’s okay, that’s fine, but then what are you going to do when your rates are at 1% and 2% and then they go up in the future? Then all of a sudden your bond price falls. You have to have this. It helps reduce volatility because the correlation is different.

Kate Stalter: Let’s backtrack a little. You had started to mention a few minutes ago some of the asset classes that you do have the holdings in. Can you mention specifically a few of the top holdings in the fund right now, and just give us some insights into why you chose these?

Stephen Hammers: Well, we don’t really have a top holding based on what we like, because all the asset classes are equally weighted. So we have a global equity hedge asset class, which is 12 of the most liquid stock markets. They’re all equally weighted based on volatility.

We are short those stock markets, because of the downward trend of global stocks, and it has helped tremendously.

We also have the same percentage in commodities. Those are the 20 most liquid commodities. We don’t overweight gold or underweight this or that; we own the individual futures. So if you looked at our fund, our top holding is cash.

It has everything to do with all the futures being backed up by 100% cash, so we don’t really take risk when we buy futures. So you may look at our fund and see 80% cash, but this fund is fully invested. This is just the way futures work.

When you look at the underlying commodities, like corn, soybeans, wheat, sugar, and gold, for example, they’re all equally weighted. It represents the futures contract on that asset. Just like if you were to buy a commodity mutual fund or ETF; they buy the futures on those assets. It’s the most liquid way you can get access to that asset class.

Kate Stalter: Now, does this mean, Stephen , that you might be trading more frequently than, say, a large-cap equity manager, for example?

Stephen Hammers: It depends on the environment. Typically, we’ll take advantage of a market based on a trend. Markets typically will go to a two-to-three-year period up and about a one-to-eighteen-month period down. Historically, our trading in terms of long and shorter hedging is about once every 18 months.

We do roll 90-day contracts, because you have to stay close when you buy a future. You have to stay close to the underlying asset in order to take advantage of the returns of that asset. If you’re too far out in your futures contract, then you’re not going to be close to the performance of that asset.

But that’s not included in mutual-fund turnover, because a future is not like a stock that you buy and sell all the time. The future is really shown up as cash, like on a Morningstar report or something. So our turnover is relatively low. We just constantly hold that futures contract and roll it.

The futures world is different than the stock world, but you know, you just have to understand it’s different. There’s no need to really dig into it right now, but it’s quite a bit different.

Kate Stalter: So it’s hard to make an apples-to-apples comparison in that sense?

Stephen Hammers: Oh, you can’t, it’s just not possible. You just have to know and the investor has to know that this is a multi-asset-class alternative fund to stocks and bonds, and it’s there to help reduce my volatility.

If I only have stocks and only have bonds, the only way to reduce volatility is add more bonds. That’s the only way to do it.

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That’s why Yale, for example, has 78% of their assets in alternatives. The average institution over $1 billion has 60% alternatives. Stocks and bonds are not their core.

So the question I ask is: Why do so many large successful institutions utilize alternatives, but most investors don’t? What do they know that we don’t?

That’s why investors need a multi-alternative type mutual fund to give them access to that, so they can help cushion the volatility that we’re in.

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