REPRINTED FROM APRIL 10, 2006 Hybrid Investing Strategies - download PDF here

ALLAN M. BUDELMAN, a Partner and Portfolio Manager of Emerald Asset Advisors, LLC, received his Bachelor of Science degree in Economics from the University of Maryland, College Park, Maryland, in 1992. He achieved an MBA in International Business from the University of Miami, Coral Gables, Florida, in 2000. Mr. Budelman has been employed as a Portfolio Adviser and Principal at Emerald from 1998 to present. Mr. Budelman was previously employed by JP Morgan from 1997 to 1998 as an Associate, Bankers Trust Company from 1996 to 1997 as an Assistant Treasurer, and Chase Manhattan Bank from 1994 to 1996 as an Administrator.

ROBERT A. ISBITTS, a Partner and managing member of Emerald Asset Advisors, LLC, received his Bachelor of Science degree in Business Administration, cum laude, from the State University of New York at Albany in 1986. He received an MBA in Finance from Rutgers University in Newark, New Jersey, in 1994. Mr. Isbitts has been employed as the Chief Investment Officer at Emerald from 1998 to present. Rob was selected by Worth Magazine as one of the top 100 wealth managers in the country for 2005. He was previously employed by Morgan Stanley & Co. from 1993 to 1995 and Donaldson Lufkin and Jenrette as a Vice President from 1995 to 1998.

MATTHEW MACEACHERN, a Portfolio Manager at Emerald Asset Advisors, LLC, attended Suffolk University, Boston, Massachusetts, where he studied International Finance. Mr. MacEachern has been employed by Emerald as a Portfolio Advisor from 2005 to present. He was previously employed by Fidelity Investments from 1998 to 2004 as a Senior Financial Planning Consultant as well as a Registered Investment Advisor with Strategic Advisors (a wholly owned division of Fidelity Investments), Leerink Swann & Co. as an Account Executive from 1995 to 1998, and Fechtor, Detwiler & Co. as a Financial Representative from 1992 to 1995.

Mr. Isbitts: Our firm grew out of a personal insurance company that was started in the mid-1980s by Bruce Levy and Scot Hunter. Their insurance clients ultimately grew to the point where they were no longer running portfolios that Bruce and Scot felt they could handle — the portfolios were getting too large — so they sought to add a separate company that would serve as a portfolio management firm, particularly for relationships of $1 million and beyond.

I had worked on Wall Street since 1986 in several capacities and was at DLJ in Miami when we found each other (in 1998) and decided to start Emerald Asset Advisors. Shortly after that, Allan joined us. He became a Partner last year. Matt joined in late 2004 after several years at Fidelity and a private money management firm in Massachusetts.

TWST: Is there an overall investment philosophy at the firm?

Mr. Isbitts: We are two things in one, I would say. Traditionally, we have been what you might call a portfolio management consulting firm. Our objective has been to figure out the highest probability of reaching a client’s goals, then finding the pieces to fill the portfolio. What happened over the years was that we became disenchanted with a lot of the traditional methods of Wall Street, including to some degree, hedge funds of funds. We were dissatisfied with the somewhat automated, "mass-customized" way that Wall Street seems to handle everything. It seemed to us that everyone was just trying to copy everyone else’s money management style, and we felt very uncomfortable with the thought of becoming a copycat firm. So we started to manage more of the money ourselves. Now, as we are in our eighth year together, we’ve figured out what we’re good at and what other people are good at — if you know the expression, "Do what you do best and outsource the rest," well, that’s what we do. So there are areas in which we are a client’s portfolio manager and there are other areas in which we remain his or her investment "quarterback." Some people access us simply for a particular strategy we developed called "hybrid," which we manage internally, while other folks access us as full-service, comprehensive wealth managers.

TWST: Do you customize at the time?

Mr. Budelman: Absolutely. When a client comes to us, the first thing we figure out is what their goal is. It's not about a specific stock or bond investment; it's more about what they want to achieve and get out of life. From there, we customize a portfolio based on their needs. So if somebody comes to us with a specific income need, we'll build a conservative, laddered bond portfolio for that client. If somebody needs to attain more growth, obviously we will blend in other types of investment vehicles — hybrid investments, equity managers, etc. — to achieve that goal.

Mr. MacEachern: We try to simplify our process and our philosophy with a few simple rules. Rule number one: Preservation; clients don't want to lose what they have. Rule number two: We want to try to grow their money as much as possible within their risk tolerance. Rule number three: Rule number one is more important than Rule number two. We believe that at the margin, doing something to protect a portfolio is more important than doing something to grow it.

TWST: Do you start with an asset allocation and then see how much to involve yourselves with the fixed income and the equities?

Mr. Isbitts: Our asset allocation is very, very different from what most people are used to. Specifically, this is because we — and most of our clients — are concerned with making money instead of beating stock market indexes. Concepts such as relative return and traditional investment style allocation are terms that are likely familiar to readers of The Wall Street Transcript. However, for us it is not a question of large cap growth or large cap value or small cap or international. We try to achieve client goals. We try to figure out the most likely way to achieve a consistent return, year after year.

We have concluded that investing today is very different from what it was in the 1980s and 1990s. Very simply, we think most of that period was a secular bull market for stocks. We think we are now in a secular bear market. And even if we’re not, we figure that if the stock market is going to surge over the next 10-20 years, we’ll get our fair share anyway, but if the historical pattern plays out and these end up being tough years, or it may even be a tough decade or so from here, we can’t afford to go back to our clients years from now and tell them that despite our best efforts the market just didn’t help us enough. So we have an absolute return focus as opposed to relative return. Many factors today are different from 10 years ago: inflation and rising interest rates are bigger factors than they have been for a while; the baby boomer generation starting to retire has a lot to do with what’s going on; and we can’t have this conversation without at least mentioning terrorism risk.

What about the investment decision making process for your equity investments? What characteristics are you looking for in the companies you want for the portfolios?

Mr. MacEachern: We’re looking for assets that generate high alpha — that is, they perform because of the manager’s skill, not just because their segment of the market did well. In down markets, this matters even more. We also favor assets that have a much lower beta (volatility) than the broad stock market, as well as a very low correlation to the broad markets. In other words, we want to find ways to succeed without much influence from the market. I’ve heard it said that many investors want relative returns in good markets and absolute returns in down markets. We start out looking at how to make money, not compete with the markets. The bonus for our investors is that we often do outperform indexes like the S&P 500, particularly in down markets.

We also look for a very low standard of deviation. If we can produce more consistent, positive returns than people are used to, we think they will be attracted to our style. Much of the investment advisory world is still caught up in how they are performing versus the market. Our clients have told us for a long time now that the market means very little to them. So why should we invest their money as if it were in competition with the market? The answer is, we shouldn’t. This is not "American Idol." This is their lifestyle we’re dealing with.

Mr. Isbitts: We should distinguish between our overall asset allocation philosophy and specifically how we use hybrid or absolute return investing as part of that strategy. For most consultingoriented money managers, equities or fixed income are the core of the portfolio. In our case, neither is typically the core. The core is our own creation, the hybrid strategy where we invest the way funds of hedge funds do, only without using hedge funds.

We use mutual funds instead. And that strategy, which has produced returns with great consistency, ends up being the core of many investors’ portfolios. Then, if there is a specific income need and we feel that can be targeted with fixed income, then we will buy a very straightforward, laddered portfolio of bonds, customized to the client. If we feel that some equity exposure is warranted, we may use a portfolio that is index based (and we actually use a firm that has been interviewed in The Wall Street Transcript in the past, Steinberg Global, to run an enhanced index strategy). But if we’re not going to index or pseudo-index, then we’re going to look for alpha. Where we often find alpha is in firms that run concentrated portfolios, meaning portfolios with typically 20 stocks or less.

What we get out of that is sometimes more volatility, but over longer periods of time, these firms have generated the ability to generate outsized returns to the point where we are quite confident that it’s not a fluke and that superior security selection is going to come from a more focused portfolio and not from buying 40 or 50 or 150 stocks. Most academic studies will tell you that dilutes the benefits of diversification.

We’re very cut and dry when it comes to this. Hybrid investing is generally the core. Fixed income has its purpose and with equities, you’re either indexed or you’re alpha-oriented in concentrated portfolios. There isn’t a whole lot in between.

At the end of the day, if our equity portfolio can’t add value over the market, then why bother? It’s much easier and much less expensive to run an index-like portfolio, but hybrids are a totally different story because there the goal is not to keep up with the stock market. The goal is to make money.

TWST: Does this hybrid type of investment you’re deploying need an up market or a down market to do well or is it good for all markets?

Mr. Budelman: It is set up to try to succeed in all markets. If you have an irrational up market where stocks are producing historically high returns, we expect the hybrid style to capture a good chunk of it but not all. In a down market, our goal is to make money (absolute returns).

Mr. Isbitts: We think it’s highly unlikely that a hybrid strategy is going to deliver, in its best of times, anything close to what an equity portfolio or an equity index would deliver in the best of times. By the same token, over market cycles or longer periods of time, we have found that very often, the more conservative, low beta, low R-squared approach of hybrid investing can deliver returns that are very similar to equities and yet you get there in a much straighter line. For the investor, that generally means that they’re less likely to want to jump ship during the "bad times" because the bad times with this approach aren’t that bad. The good times aren’t that good, but the bad times aren’t nearly as bad and it keeps people more on path toward what they’re trying to do with the money as opposed to chasing market trends.

Mr. MacEachern: And that’s the main basis of how we came up with this strategy. Clients were okay with giving up some performance in the up years for the ability to make money or tread water, so to speak, if the markets go against them.

TWST: Would you describe a typical portfolio for us and explain your reasoning in selections and so on to give us a representative feel for your portfolio construction?

Mr. MacEachern: I know it’s typical that people will give you some of their favorite stocks at this point in time. We can talk a little bit about some of the asset classes we use in our hybrid portfolios and describe some of the funds that fall into these categories.

For instance, in the core part of our strategy, we use managers that run styles such as market-neutral, long-short equity, high yield debt, event arbitrage and convertibles. We may also allocate to funds that are dedicated to shorting stocks or bonds, distressed debt, commodities, and real estate investment trusts (REITs).

Mr. Isbitts: We haven’t found many firms at all that are doing this type of portfolio work to the extent that we are. The hedge fund of funds industry has grown by leaps and bounds, but the hedged mutual fund industry is very much in its infancy. We find that people use a couple of funds here and a couple there, but we believe we are years ahead of the pack in terms of researching these styles. We created a sort of an educational tool called the Emerald Hybrid Strategy several years ago in order to educate our clients and the industry about this additional asset class that we define.

Mr. MacEachern: I can give you a great example of what we consider a hybrid fund. It is called the Permanent Portfolio (PRPFX). The typical allocation of this portfolio includes gold, silver, Swiss-denominated assets, global real estate, aggressive growth stocks and US Treasuries.

The question we would ask your readers would be, "What Morningstar style box does a portfolio like that fit into?" And the answer is, "None." This is something that really transcends the traditional asset allocation thinking, which says, if you fill all your large, mid- and small cap and your growth, value and core slots, you’re going to smooth out your returns. We don’t feel diversifying from one traditional asset class to another to another gets people as far as they’d like toward achieving consistent returns.

TWST: Do you have any other examples you want to illustrate here?

Mr. Budelman: Another one we use is the James Market Neutral Fund (JAMNX). It’s a quantitatively-driven portfolio where their research leads them to about 20 of their best ideas. They also identify about 20 companies whose stocks they expect to fall in price. They short those positions. This leads to a portfolio that is roughly equally divided between long and short positions. This is called a market neutral portfolio, and it’s a style practiced by many hedge funds — and, as we’ve discovered over the years, by some mutual funds too.

Mr. Isbitts: There’s one I would add. To me, it’s kind of the granddaddy of hybrid investing, because it’s been around since the late 1970s. That is Gateway Fund (GATEX). The Fund owns the S&P 500, so it starts out as your typical index fund, but what they do that is different is to actively manage an option collar around the index, where they’re either selling calls on the S&P or they’re buying puts on the S&P or both. They use the premiums they receive from the calls to fund the cost of the puts and so again, when you invest in this way, the bottom line is they’re capping their downside and their upside and they’re making most of their money from the option premium they receive.

There was a point at which the S&P 500 was down 35% in the depths of the bear cycle we had from 2000-2002. The S&P was down 35% and Gateway was flat. They didn’t make money, but it sure took a lot for them to even go flat. That Fund has been around for a long time. I think in a lot of ways it symbolizes very simply how you can take traditional investing and simply add an option overlay strategy, package it as a mutual fund and now you have a much more consistent return.

TWST: What type of investor does this hybrid investing appeal to?

Mr. Isbitts: That’s a question that we have been pondering for a little while because our own clients have loved it and continue to love it, but we started to realize that the vast majority of investment advisors are unaware of the lengths to which you can take this type of strategy as a substitute for a hedge fund of funds.

Mr. Budelman: When you speak to a lot of advisors, they may have heard of a couple of these funds we deal with, but they’ve never seen it collectively put together as a strategy that’s actively managed. I’m finding that when you deliver this to either individual investors or to advisors, they’re blown away because they’ve never seen anything like it outside of the hedge fund structure — a portion of their portfolio that’s divorced from the market in a way and not so correlated and dependent on what the stock market is doing. It applies to all different types of investors, anybody who wants to have a smoother stream of returns and path of growth, so they’re not as worried, when they see the market’s going down, that they will be so heavily impacted.

>Mr. MacEachern: A better question would be, who isn’t this for? The question is, how much is appropriate, depending on your risk tolerance and time frame. I don’t know anyone who’s not looking for a more consistent stream of returns. The question is, to what degree?

Mr. Isbitts: In particular, if you buy into the idea that the 1980s and 1990s were secular bull markets (when stocks generally rose in value) and this decade and perhaps this generation is going to have to learn how to survive a secular bear market for stocks (where losing periods are more common and sustained growth is tougher to come by), you realize that the ways you are used to investing may not work for you anymore. Now, add the fact that interest rates are in a rising trend for one of the few times in the last quarter of a century, which means that your approach to bond investing needs to be adjusted. When you put those things together, if you buy into the idea that that is a real possibility (and we do), then this style of investing should certainly appeal as a complement or even a substitute for traditional stock-and-bond balanced portfolios, or either one on their own.

Mr. MacEachern: One of the things we try to do is to define what a hybrid is. A hybrid according to us is an investment vehicle whose expected returns are greater than that of a five-year AAA bond but whose expected volatility is noticeably less than the broad stock market. Another way to define a hybrid approach is flexibility, the ability to do different things when the markets change and to think differently from your traditional large cap or small cap fund that has to stay 90% invested and can’t change when the market changes, per its charter.

TWST: Do you replace funds that are not performing as well?

Mr. Budelman: Absolutely. We’re always examining whether to replace or tweak our allocations or add a new style of fund to the portfolios. If we feel that, for instance, convertible bonds are a little more interest rate sensitive than we like, then some of that allocation will be pared down. The annual portfolio turnover is expected to be between 25% and 75%.

When we’re looking at these funds, we do a quantitative screen and we look to make sure that there’s style consistency within our hybrid objectives. We look at a fund’s turnover. We feel that high turnover is okay if the performance is strong. That means that the manager believes their style is most effective when positions are held for a shorter period of time. We also look for unrealized capital gains. If we’re running this in a taxable portfolio, obviously taxes are a consideration for the client. We pride ourselves on being tax-aware in the hybrid strategy and in our portfolio approach in general.

Mr. MacEachern: One other thing I think is also important is not just looking at past performance annually, but taking a look at the best and worst periods to see what these funds have done. We want to see what a fund’s biggest drawdowns were on a rolling basis and what caused that. Only then can you start to get a feel for the risk in a given fund.

Mr. Isbitts: I’ll take you through the rest of the research process. There is also a fundamental side to this, a pretty serious one. We regularly interview the fund managers and everything that they write. We have some alert systems we’ve set up to catch news on a fund, such as an updated holdings list being released. Because mutual funds don’t tell you their holdings every day, we want to know as soon as a new portfolio is available. We want to gain as much transparency into what they are doing as possible. If a manager is changing their thinking, we want to know how and we want to see if it makes sense to us. If the macro environment is changing in the economy or the markets, we want to gauge the potential impact on the funds from that.

We certainly look at market valuation ratios. Certain funds are going to perform better in a low or a high price/earnings environment, for instance. Styles such as REITs look more attractive when their yields are high relative to the bond market, so that always factors into the analysis. We certainly watch bond interest rates and the yield curve, as well as economic indicators of many kinds. In particular, we’re watching the twin deficits that the US is carrying. Despite the fact that corporations are in pretty good shape, with a lot of cash at their disposal, the government and consumers are not faring as well. That is something that may have a significant impact in the future. As a strategist, you have to watch how that evolves.

Also, there are particular data points that I think absolute return investors would look at a bit more closely than traditional stock pickers. This includes things like short interest. It certainly impacts the short categories that we use. Merger and acquisition volume impacts merger arbitrage. The default rate on high yield bonds has implications for high yield and other types of hybrid fixed income vehicles.

At the end of the day, having a sell discipline is probably the most important thing because I think most of these strategies will work out pretty well as long as you don’t allow the volatility they do have to get you. We will make a change in a fund if the price objective that we’ve set is achieved or when changes have occurred in the economy. Management changes will always call for re-evaluation of the fund. If the entire management team has left, we are very likely to sell that fund because the people make the track record and not the firm. A lot of these funds tend to be entrepreneurial and are not run by the very biggest fund companies.

If a firm becomes too institutionalized, meaning they start to take their attention off of managing money and pay too much attention to commoditizing what they have, sometimes that will show up. It may show up in the fund’s returns or it may have the potential to and that’s something we try to gauge. We’ve seen a lot of firms do well and then things turn badly when the firm starts to get too institutionalized. Finally, it certainly will happen from time to time that our investment thesis was just plain wrong. The key there is to make sure that if we’re wrong, we cut the damage right away instead of praying that it comes back. That’s something that an equity manager with a 10-year time horizon can live with a lot more than we can, since we are trying to produce more consistent returns year to year.

TWST: What about risk in the portfolios. Is that a focus?

Mr. Isbitts: It is the number one focus. We spend as much time figuring out how not to lose money as how to make money. Everybody tends to have winners and losers, but the people who cut the losers and let the winners run tend to produce better results. Again, since our benchmark is not a stock index but we rather try to deliver a consistent, positive return, that’s even more meaningful to us than it might be to an equity manager or a fixed income manager. Those firms often write about their performance in relative terms to a benchmark. That works for them but we answer to a different calling, so to speak.

The people who seem to embrace this strategy the most are the ones that are tired of hearing that the market was down 20%, but their manager did a good job because they were down only 15%. As they say, you can’t eat relative returns. But, as Matt said, who can’t benefit from this strategy? I think the people who will probably get the greatest benefit from it are those who react the way I just explained. They’re not impressed by relative returns. Most of our clients are not, so we cater to that belief.

In particular, I think the baby boom generation is really going to get a lot out of this approach to investing because a lot of baby boomers have made the decision that they don’t want to go through a repeat of what occurred in the early part of this decade.

Once they’ve made that decision, if they talk to their advisors, the pat answer is usually, "Use hedge funds or hedge fund of funds." Wall Street is coming up with a lot of new inventions to pursue that, but from what we can surmise, it’s the right approach but the wrong vehicle. They can pursue absolute returns, but there’s not enough transparency in hedge funds for a lot of folks, including us. They can’t see what’s going on in there. The liquidity is often limited and the costs can be anywhere from high to outrageous and they’re not easy to discern all the way through, all the way down to the fund manager level.

Matt refers to this as the "TLC" of the hedge fund world: transparency, liquidity and cost. The problem is, as I’ve just described, there isn’t a lot of tender loving care going on there. So we are trying to combat that for our clients by running a strategy that gives them what they would want out of a hedge fund of funds without the baggage, so to speak.

TWST: Hybrid is a very exciting concept. Has it been growing in the country that you’re aware of?

Mr. Isbitts: I’m going to cite a study from November 2005 by Cerulli Associates, the esteemed Boston research firm. In their 200-page report entitled, Hedge Funds: The Market For Absolute Return, Cerulli noted two points that really helped validate what we are doing. I’ll quote directly: "…clearly some of those investors are more comfortable with mutual fund fees, since half of them said they would rather invest in hedge fund strategies that are found within the mutual fund format…" And also: "Mutual funds with a hedge fund bent are becoming more widely available. We estimate that US$200 billion to US$300 billion in mutual fund assets are actually invested hedge fund-type strategies…"

Matt and I presented our hybrid approach at the 2006 World Money Show in Orlando, and it received a very strong reception. Let’s put it this way: our session ran about 40 minutes and the questions from the audience ran another 50 minutes. It was a rousing and very enthusiastic discussion. What typically happens is, we start to describe this strategy and, for about 10 minutes, people are trying to figure out where we’re going and then when they finally see what we’ve put together, the light bulb goes on and in a lot of cases, they never look back.

I’ve been on Wall Street for 20 years. I’ve seen it from many angles, from the systems business to administration and operations to the brokerage business, trust companies and, finally, for the past eight years, I’ve been running an independent investment advisory firm, which I believe is by far the best structure for most affluent and semi-affluent investors. I’ve written over 50 articles and commentaries to our clients over the years. I was encouraged by several people to try to take that and make it the basis for a book. We’re targeting an April 2006 release. The name of the book is Wall Street’s Bull and How to Bear It. It is my guide to investors and their advisors to help them figure out what they really want out of their money, how Wall Street can help and how it can hinder.

TWST: Any final thoughts?

Mr. Isbitts: At each stage of their lives, the baby boomer generation has had a significant impact on the world. Now the oldest boomers are starting to turn 60 and the youngest are well into their 40s. This should certainly impact the way the financial markets behave. And that in turn impacts all investors, regardless of age and wealth segment. This is just one of the many reasons that investors have to re-program their thinking. As they do, they will likely find they want more than the same old commoditized approaches. Wall Street is starting to look the same to them. We feel we are making a reputation for ourselves as folks who are discovering ways to improve upon the portfolio management "status quo." It’s very serious business but we are having a lot of fun doing it. We intend to keep going.

TWST: Thank you.