Markets are Volatile!
Which alternative investment strategies can best protect your clients’ profits?
June 24, 2019
Alternative Investment Strategies Have Historically Demonstrated the Ability to Reduce Risk
Listed below are some areas of opportunities during market volatility.
Hedge Fund Strategies
Relative Value funds do not take directional market risk insulating their investors from volatile market moves. Relative Value funds are focused on capturing spreads between highly correlated securities. When the spread widens between related securities, these funds put on trades that can benefit from spread tightening.
Distressed funds buy and trade bonds and other instruments that have typically sold off before the Funds became involved and are thus less sensitive to overall market moves. Funds also drive performance through active involvement in bankruptcy/restructuring processes.
Macro/ Managed Futures
Macro & managed futures funds buy and sell a wide array of instruments that are uncorrelated to broader equity markets such as foreign currencies and commodities. They have the ability to capture downward moves in equity markets via shorting.
Private Equity Fund Strategies
Private credit has been one of the safest corners to invest in over the past 30 years, and is expected to do well even if the broader market environment turns for the worse ¹. Private Credit funds target the ownership of higher yielding corporate, physical (excluding Real Estate), or financial assets. Credit exposure can be either corporate, with repayment coming from an operating company’s cash flows, or asset based, with repayment coming from cash flows generated by a physical or esoteric asset. Private Credit strategies include mezzanine and senior debt funds, distressed credit and credit opportunities funds.
Small and mid-market buyouts have historically been outperformers on a risk-adjusted basis ². The Leveraged Buyout (LBO), or Buyout, strategy looks to borrow a significant amount of capital from loans and debt to acquire a company, business unit or business assets from the current shareholders. Firms focus on buyout investments when they believe they can extract value by holding and managing a company for a period and exiting the company after significant value has been created. The goal of the Buyout strategy is to generate returns on the acquisition that will outweigh the interest paid on the debt.
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Alternatives Have a Long Track Record of Reducing Volatility and Adding Yield
- Low Correlation to Other Asset Classes
- High-Risk Adjusted Returns
Hedge Funds are Volatility Dampeners
Hedge fund volatility has been consistently lower over trailing three-year periods for more than a decade.
Research has been conducted into how public markets and the buyouts corner of the private market had fared during various periods of volatility. As the chart below shows, returns from stocks in excess of the risk-free rate have buckled in the most volatile environments, as one would expect. Returns from buyouts, however, have maintained their premium over stocks across volatility regimes.
Source: Business Insider June, 2019
What the Experts are Saying
OCIOs Expect More Money to Flood into Alternatives
Consulting firm Cerulli Associates’ survey³ found clients of outsourced chief investment officers are planning to trim their exposure to stocks in favor of alternative assets, amid fears of a coming downturn.
Investors are paying close attention to portfolio diversification and the low correlation of many alternative asset classes to public investments, particularly equities.
Persistent single-digit equity returns and relatively low interest rates make it challenging for investors to reach target returns using only public investment opportunities.
While public and private pensions number among the industry’s largest investors, representing close to 40 percent of total hedge fund capital in 2017, other client types are gaining in importance. For example, private wealth clients, including wealth managers and family offices, are among the fastest-growing sources of hedge fund capital, according to the consulting firm.
Shifting market conditions, including rising volatility, drive demand for varied strategies. Investor interest in global macro and multi-strategy credit could indicate greater interest in volatility dampening strategies.
- Laura Levesque, Senior Analyst at Cerulli
The Need for Active Management
In times of volatility, a more hands-on approach to investing often leads to better returns. According to Deutsche Bank, an active investing strategy for stocks can outperform the overall market by taking advantage of short-term price fluctuations. Passive investors, on the other hand, are in it for the long term and limit the amount of buying and selling within their portfolios. Passive investors usually allocate to assets that mirror the composition of major stock or bond indices. There are many alternative investment strategies designed to capitalize on exactly those opportunities volatility creates and passive investors ignore.
I think in this environment, it would be prudent to raise cash, but also secondly, try to reduce passive investment strategies, (exchange-traded funds), and also go into investments that are active, where you have some ability to also raise cash, also have the ability to look into non-index stocks.
Our portfolio construction has shifted into more flexible mandates, unconstrained strategies that potentially can benefit from higher volatility. Because I think whatever everyone seems to agree upon is that ... volatility is rising.
- Rainer Michael Preiss, Executive Director at Taurus Wealth Advisors
Source: CNBC August, 2018
Volatility is Here to Stay
While many economists say the US economy is stable, risks are looming⁴, most notably threats of tariff-driven trade wars with China, Mexico and others that damage business, household and investor confidence. The Fed’s direction and action with interest rates is also a threat, and—because of the country’s ballooning budget deficit—fiscal policy is in a weaker position to help through spending or big tax cuts if the economy becomes stressed.
Another sign of the current climate of volatility—we are witnessing an inverted yield curve. This has historically been viewed as a sign that a recession may loom ahead. The yield on the benchmark 10-year Treasury note fell below 2.07% on June’s first day of trading as mounting global growth fears pushed the rate to its lowest level since September 2017. The 10-year yield’s tumble from 2.5% at the beginning of May inverted a portion of the yield curve, with the 3-month bill rate trading above its 10-year counterpart⁵.
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