Posted by Fundmentals on November 06, 2009 at 19:28:16:
In Reply to: Ping Fundamentals - Why do you own both ARBFX and MERFX? ntip posted by BY on November 06, 2009 at 18:54:19:
This is the same as not putting all eggs in one basket but for different reasons than the usual diversification argument.
Both ARBFX and MERFX behave in very similar fashion most of the time with some difference in volatility. They are actually reasonably correlated funds. Diversification between them will not reduce market risks where both of them may go down due to market conditions. Nor will the performance suffer from diversification since they are fairly well correlated.
But in actively managed funds like this, there is another type of risk which is unrelated to market risks usually labeled idiosyncratic risks. This may arise because the specific strategy used by a fund may backfire at times (presumably it is an exception than the norm for you to have considered the fund), or a manager mistake or any such non-market related and fund-specific risks may occur.
A good example is the performance of Hussman towards the end of last year in his strategic growth fund where he lost more than what one would have expected.
ARBFX may make a wrong bet on a particular merger transaction. MERFX may find that its much bigger size a liability in getting out of a bad situation. These are all fund/strategy specific risks.
Such idiosyncratic risks can be reduced by diversifying in funds of similar strategies. You are not trying to improve returns via diversification but just trying to remove a single point of failure (a single fund) from affecting your portfolio too much.
An analogy I use is having redundant computers working independently for flight controls. All of them are doing the same thing most of the time and so one would be sufficient if that were always the case. But if one of them were to run into an unexpected hardware/software bug and others were not duplicates of the same software/hardware, then the effect of the one with the glitch is minimized until it recovers as opposed to having just that one!
I feel more comfortable with such diversification when there is active management involved especially in these alternative investment strategies.
: : I recently added some allocation to ARBFX and MERFX in my conservative taxable portfolio as low volatility, reasonably (but not entirely) major market uncorrelated funds.
: : The linked article on the Buffett takeover of Burlington Northern shows how these funds (or funds also using this strategy) make money.
: : A slow recovery with a raising market is a good environment for a lot of takeovers and mergers as the winners gobble up losers of the recession as organic growth is limited.
: : These funds are not to be confused with some exotic hedge-fund arbitrage strategy and will not be very flashy but will reduce the volatility of a portfolio (like bond funds) with potential for equity like gains.