Portfolio Protection Using Alternative Investments
The Covid-19 pandemic has had an unprecedented impact on corporate earnings and has significantly increased the correlation between traditional asset classes like bonds and equities, according to Institutional Investor. A portfolio that combined both equities and fixed income likely provided little diversification benefits during this time. As a result, the current lack of a clear resolution to this crisis raises a key question: what options are available for investors seeking to protect their portfolios while remaining invested?
It All Starts with Math and Numbers Don’t Lie
Correlation statistically measures the degree of relationship between two variables that numerically lies between +1.0 and -1.0. In the world of investing, correlation represents the degree of relationship between the price movements of different assets included in a portfolio. A correlation of +1.0 means that prices move in tandem, while a correlation of -1.0 means that prices move in opposite directions. A correlation of 0 means that the price movements of assets are uncorrelated; in other words, the price movement of one asset will not affect the price movement of the other asset.
In actual practice, it is difficult to find a pair of assets that have a perfect positive correlation of +1.0, a perfect negative correlation of -1.0, or even a perfect neutral correlation of 0. A correlation between different pairs of assets could lie anywhere between +1.0 and -1.0 (for example, +0.62 or -0.30). Each number tells you how far or how close you are from 0 where two variables are uncorrelated. So, if the correlation between Asset A and Asset B is +0.35 and the correlation between Asset A and Asset C is +0.25, then you can say that Asset A is more correlated with Asset B than it is with Asset C.
If two pairs of assets offer the same return at the same risk, choosing the pair that is less correlated decreases the overall risk of the portfolio, thus providing diversification and portfolio protection. In other words, if one element of a portfolio ‘zigs’ while the other ‘zags’ but earns similar annualized average returns, the result is a portfolio with lower aggregate volatility.
Hedge Funds as Fixed Income Replacement for Portfolio Protection
Due to historically low interest rates and highly priced bond markets, investors are looking for alternatives to fixed income as a hedge to their equity portfolios and leading some to explore a particular area of the hedge fund landscape — Global Macro hedge funds, as reported by the Financial Times. As bond prices have soared to record highs this year, driven by interest rate cuts and a flight to safe-haven assets during the coronavirus pandemic, many investors have grown wary of the traditional 60/40 blend of stocks and bonds that has been the mainstay of investment portfolios for decades. Because short term interest rates are at 0% and bond prices are so high, the growing perception is that there is little room for bonds to appreciate further and compensate for losses from a stock sell-off.
During the decades-long fixed income rally, bonds have had a long-term record in offsetting equity losses, and a 60/40 portfolio would have made money for investors for most of the past 40 years. The fixed income portfolio had served as a viable ‘shock absorber’ to the portfolio while also contributing modest returns. However, the desire to find a replacement has grown this year as bonds have rallied, sending the US 10-year government bond yield down from about 1.9% at the start of 2020 to just above 0.8%.
Some investors are now looking to macro hedge funds as an alternative for portfolio protection. These funds, which bet on moves in global bonds, currencies, and stocks — and which were made famous by billionaire trader George Soros — are enjoying a renaissance this year, helped by big swings not only in bonds but also gold and stocks. “The traditional role of fixed income as a diversifier is certainly more challenged,” said Karen Ward, chief market strategist for EMEA at JPMorgan Asset Management. Macro funds could be a good replacement, she added, given many of these strategies aim to make money during periods when investors sell risky assets.
“Macro funds have certainly performed well during periods of volatility,” she said, adding that the question of whether products such as macro funds can replace bonds is “now at the forefront” of investors’ minds.
Macro hedge funds find new role - as portfolio hedge
Macro hedge funds — which by some estimates make up about 18% of total hedge fund assets — tend to be far less exposed to overall stock market moves than the wider industry and made money in negative years for equities such as 2000, 2001, 2002, and 2008, according to an analysis from JPMorgan. Alan Howard’s Brevan Howard, for instance, one of the best-known macro funds, made gains of more than 20% in both 2007 and 2008 during the credit crisis.
During much of the bull market in equities over the past decade, macro funds delivered only lackluster returns, persuading many investors to pull out their cash. But this year, funds such as Caxton Associates, Brevan Howard, and Rokos Capital are among those that have chalked up double-digit returns, said people familiar with their returns. Much of the gains have come during the choppy opening few months of this year when equities slumped on fears over the economic damage from the coronavirus pandemic.
More Pain Projected for the Traditional 60/40 Portfolio
JPMorgan Asset Management is cutting its projections for cross-asset returns over the next decade and signaling more pain for 60/40 allocations that have long formed the bedrock of traditional portfolios.
Such a balanced approach will earn 4.2%, down from 5.4%, in coming years, according to the $2.3 trillion fund manager in a presentation on November 12, 2020. Strategists at the firm reduced their forecast for global equities by 1.4 percentage points to 5.1% in the next decade, citing elevated valuations in U.S. large caps. They forecast negative inflation-adjusted returns across almost all sovereign bonds over the next 10 to 15 years, with yields remaining low even after rates normalize.
The forecasts further undermine faith in decades-old investment strategies that aim to balance the risks of stocks with the safety of bonds. The approach allocates a majority, 60%, to equities tied to economic growth, while the remainder is invested into bonds for portfolio protection.
Stock-bond frontiers are meaningfully lower than last year, showing the combined impact of ultra-easy monetary policy compressing yields and fiscal plus monetary stimulus together boosting equity valuations.
A new portfolio for a new decade
Source: J.P. Morgan Asset Management; estimates as of September 2020 and September 2019. EM: Emerging Markets; DM: Developed Markets
“To navigate the new decade, investors may consider diversifying from traditional safe assets that no longer offer income, and toward alternative assets that more fully exploit the specific tradeoffs that a portfolio can tolerate to potentially find higher returns,” said John Bilton, head of global multi-asset strategy at JPMorgan Asset Management.
Alternatives AuM Will Surge to More than $17tn by 2025
Preqin expects AuM growth in alternative assets to average 9.8% per year to 2025. Persistently low-interest rates will attract investors of all types drawn to the promise of outperformance, diversification, and lower correlation with public markets. The forecast is supported by Preqin’s Future of Alternatives 2025 survey, in which 81% of investors said they expect to increase allocations to alternatives.
Alternative assets under management ($tn)*