A Risky Technique That Could Boost Your Returns

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The Holy Grail of investing is producing big returns without taking on too much risk. Yet while asset allocation techniques have been around for decades, a new type of asset allocation is borrowing a page from one of the hottest dividend sectors of the market to provide an innovative way of investing that it hopes will balance risk more evenly across your portfolio.

Being fair about risk
Balanced-risk or risk-parity funds are a relatively new phenomenon. As an article in TheWall Street Journal detailed earlier this week, the funds attack the traditional mix of stocks and bonds on the basis that the stock side of the portfolio ends up with the lion's share of the risk. As a result, investors are left at the mercy of the stock market -- and if stocks do badly at the wrong time, it can have a huge impact on someone trying to save for retirement.

Part of the advantage of these new funds comes from a broader spectrum of assets. For instance, Invesco's balanced-risk fund, which had a return of more than 10% in 2011, includes commodities, which over recent years have performed better than the stock market.

Levering up
But in order to put lower-risk bonds on an even keel with higher-risk stocks, some balanced-risk funds turn to leverage. By using futures or other derivatives, fund managers can magnify the impact that bonds have on the overall return of the fund.

Interestingly, that's pretty much the exact method that mortgage REITs use to produce high-dividend yields. The agency-backed mortgage securities that Annaly Capital (NYS: NLY) and American Capital Agency (NAS: AGNC) invest in don't produce spectacular returns on their own. Only by levering up their mortgage-security portfolios significantly -- not quite six times for Annaly, and more than eight times for American Capital Agency -- can those stocks produce the double-digit yields they pay as dividends.

Of course, some of the impact depends on which kinds of bonds you buy. Chimera (NYS: CIM) and Invesco Mortgage Capital (NYS: IVR) have part of their portfolios in non-agency mortgage bonds, which boosts yield. Chimera maintains much lower leverage than Annaly or American Capital Agency, yet it produces a similar dividend yield.

Similarly, by choosing different allocations of Treasuries, high-quality corporates, and junk bonds, balanced-risk funds can decide how big a component leverage will be in the overall risking-up of the bond side of the portfolio.

Betting with the bond bulls
This strategy has worked very well in recent years, as it gives more weight to bond investments than the typical portfolio does. With bonds having been especially strong lately, balanced-risk funds have profited immensely from the bull market in fixed income.

But just as mortgage REITs have relied on low short-term rates to subsidize their borrowing and maintain strong interest spreads in their portfolios, so too do balanced-risk funds rely on the continued availability of cheap leverage to make their positions viable. When interest rates rise, the costs of keeping levered positions will rise along with them -- and that should result in lower returns for the funds.

Keep it real
As scary as that strategy sounds, it's one that institutional investors have started using. Two years ago, the State of Wisconsin Investment Board started using a similar leveraged-bond portfolio in an attempt to boost their returns to meet what have turned out to be unrealistic expectations.

Before you make a big bet on balanced-risk funds, wait to see how they perform in a higher-rate environment. These funds don't have a long enough track record for us to predict exactly what they'll do when rates start to rise. Although fund managers may successfully take steps to limit risk in a rising-rate environment, you probably don't want to put yourself in a position in which you're counting on them to do the right thing.

Stocks certainly have risk, but the right ones can get the job done for your portfolio. Find out about three promising choices in The Motley Fool's latest special report, where you'll find smart plays for long-term investors. The report is free -- but don't wait: Click here and read it today.

At the time this article was published Fool contributor Dan Caplinger wonders how much financial innovation actually results in progress. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Chimera Investment and Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is never risky.

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