Reuters Money

By Karyn McCormack

Arne Espe, 50, spends most days scouting out the best fixed-income investments at USAA Investment Management in San Antonio. The fund he manages, USAA Cornerstone Strategy fund, has been around for 27 years and is a diverse portfolio of stocks, precious metals, commodities, bonds and REITs. “It’s a one-stop shop,” says Espe. “If you have to have all your eggs in one basket, this is it.”

Espe runs the fund along with John Toohey and Wasif Latif, plus a team of 18 analysts, whose work is behind USAA Cornerstone Strategy’s 2011 Lipper Fund Award for three-year consistent return in the Global Flexible Portfolio Funds classification. USAA Cornerstone Strategy’s annualized three-year return is 0.09 percent, beating the 0.22 percent average decline for similar funds that Lipper tracks (through Dec. 31, 2010).

The main driver of the fund’s consistent return is active bond management, Espe says. Bonds — primarily investment-grade corporate bonds and commercial mortgage-backed securities (MBS) — make up 36 percent of the fund. The bond portion of the fund has generated a 15.1 percent return over the last three years vs. 5.5 percent for the Lipper Intermediate Bond Index. “The financial crisis gave us once in a lifetime opportunities,” Espe says. “We found incredible value in commercial mortgage-backed securities.” When the financial crisis hit, he explains, hedge funds and other “fast money” investors dumped commercial MBS, driving prices to very low levels. Espe and his team analyzed the money good bonds and saw no defaults in the area so they were able to purchase some commercial MBS for as low as 50 cents on the dollar for the fund.

Subordinated debt and preferred stocks issued by banks and insurance companies also “provided fabulous returns,” he says. On the equity side, positions in miners of gold and other precious metals, REITs and emerging markets stocks helped drive the fund’s performance, he says.

Careful asset allocation is another key to the fund’s success, Espe says. The portfolio is managed with a short-term view about which asset class will outperform based on valuation within the next 12 months. For example, the team determines whether stocks are cheaper than bonds and what they want to own more of. The team meets once a week to review the portfolio and market conditions. During the last three years, they’ve made asset allocation changes two or three times a year.

The managers dampen volatility in the fund by hedging stock positions using a costless collar strategy (selling out-of-the-money call options and using the proceeds to buy out-of-the-money put options). This hedging technique is done within a narrow price range (the call option gives a ceiling and the put option establishes a floor price for the stock), which can limit a higher return, but offers protection from losses when stocks are falling.

For now, Espe and his team favor U.S. large-cap stocks over small caps given that large-cap valuations are more attractive. The S&P 500 index is trading at 13 times forward earnings, vs. 22 for the Russell 2000 index. Along with higher expected returns for large-caps, Espe believes that large-cap stocks also carry lower volatility and risk, and should hold up better if the market drops. The fund remains overweight in U.S. high-yield bonds, REITs and precious metals stocks (two of its largest precious metals positions are Goldcorp and Barrick Gold).

On the flipside, the managers recently lowered their weighting of emerging markets stocks to market weight from overweight given their concerns about inflation and monetary tightening in China. In addition, they’re underweight Europe because of the continuing financial troubles and threat of sovereign debt default by Ireland and Greece.

Down the road, Espe believes investors will feel the continued effects of the Federal Reserve’s monetary policy. “I think inflation is probably the biggest risk investors will face in the next 10 years,” he predicts, although it won’t be a problem for the next year. Still, USAA Cornerstone Strategy fund continues to hold inflation hedges like gold mining stocks in anticipation of what’s to come.

Espe, an Alaska native, likes to tackle challenges outside, too. After three previous attempts, in 2005 he completed the Big Horn 100, a 100-mile marathon in Wyoming. (It took him 33 hours). As if that weren’t daring enough, he likes to go heliskiing — that is, taking a helicopter to the top of mountains in Canada for back-country downhill skiing.