It has been a good run. Ten years after the 2008 “meltdown,” the bull market in securities is beginning to show its age. And, after a very placid 2017, volatility in the market is showing it’s alive and well. That volatility has been driven by interest rate expectations, trade/tariff discussions, and the mid-term elections. The elections are (mostly) behind us, but volatility may still be around for a while. Investors have made some money with this long bull market; now the goal is to protect those gains.
Alternative investments can play a major role in hedging risk in the stock market; however, there are many different hedging strategies available. Many investors are not familiar with these strategies or how to access them. In general, there are two broad categories of alternatives: 1) those investments offering diversification from the stock market, and 2) those investments that reduce risk of loss of portfolio value while still maintaining some return potential.
Access to hedging strategies used to be a major problem; lack of liquidity (the ability to easily buy and sell) being a prime example. Many of these strategies are now available in a mutual fund format. Shares can be purchased or sold daily with valuations set at the end of the day. Some strategies are available as exchange traded funds (ETFs) which provide intra-day liquidity.
Correlation is an analysis of the relationship of two data variables, or how the variables move in relation to each other. Normally this relationship is combined into a single number—the correlation coefficient. A correlation coefficient can have a value of +1 to -1. A value of 0 indicates that the variables have no relationship, i.e. they are independent. Positive values (>0) imply that when one variable goes up, the other variable goes up also. Negative values (<0) imply that wen one variable goes up, the other variable goes down. The magnitude of the number (the closer the coefficient is to a value of +/- 1) explains the degree to which moves in one variable are like moves in the other variable.
Since most investment portfolios contain stocks, alternative strategies which have a lower correlation to them can provide diversification benefits. Listed below are three strategies which have lower correlations to the S&P 500 over the last 10 years.
- Managed Futures- A fund manager utilizing this strategy usually invests in different asset classes (both long and short positions) depending on the manager’s analysis of which asset classes are going to increase or decrease. Successful ability to capture both rising and falling markets have a substantially different return profile from the stock market—a correlation coefficient of about -0.10.
- Market Neutral- A market neutral manager usually has a portfolio long (owned) on stocks the manager expects to rise and short (sold) on stocks the manager expects to under-perform the market. When the portfolio has similar long and short holdings, the return of the portfolio has returns less related to the stock market- a correlation coefficient of about +0.34
- Multi-currency- A multi-currency manager usually invests in different currencies depending on the manager’s perceived relative strength. Since returns are usually different between stocks and fixed income investments, this strategy has had a correlation coefficient of +0.48.
Risk Reduction Alternatives
Ideally, investors would like a diversification strategy that doesn’t significantly sacrifice returns. Such strategies would not only have less losses in down equity markets, but would also have more positive returns in up equity markets. Over longer time periods, these alternatives would outperform those alternatives that provide only downside risk mitigation. Examples include the following:
- Long/Short Equity- A long/short manager usually has a long (owns) position in stocks in which the manager expects to outperform the market and short (sells) stocks which are expected to under-perform the market. The manager may use the sale proceeds from the short positions to increase his/her holdings in the long positions.
- Non-traditional Bonds-Such a manager usually has the ability to invest in bonds of varying maturities, differing credit quality, differing economic sectors, or varying geographic areas as the manager perceives have value. A successful manager has the ability to move according to interest rate changes and other variables affecting the returns markets.
The Bottom Line
Make no mistake—investing involves risk! So does putting money under the mattress in times of inflation. However, if one can mitigate risk (even in a minor way), it surely is worth the effort. Please contact us at Paragon Financial Advisors to see if such alternative investments might benefit your investment portfolio. Paragon Financial Advisors is a fee only registered investment advisory company located in College Station, TX. We offer financial planning and investment management services to our clients.