Negative yielding bonds overseas, coupled with slowing growth due to the trade war with China and a dovish Fed, has pushed long-dated Treasury yields to historically low levels.1 Investors searching for income have gravitated toward the defensive sectors of the stock market, particularly the RUST sectors (i.e., REITs, Utilities, Consumer Staples, and Telecom), resulting in them becoming expensive from a price to earnings metric and in my opinion could be vulnerable to a correction.
Investors have now been essentially forced to accept low Treasury yields (which have become particularly volatile) or else choose to move out on the risk spectrum to high-yield bonds or the overall stock market. However, high-yield spreads are historically narrow, and stocks are near all-time highs2, which both warrant caution for new capital. Moreover, because we are in the latter stages of this economic cycle (as evidenced by the recent yield curve inversion), risks are mounting within traditional asset classes. This is why I believe investors should consider exploring alternative investment strategies, which can help mitigate risk and have the potential to enhance returns.
Alternative investments are a broad investment category, including everything from real estate and commodities to fine art and classic cars. The goal of adding alternative investments to one’s overall portfolio is to enhance diversification to assets that have unique investment characteristics and low correlation factors that are not dependent on stock and bond market performance. Although there are a vast number of alternative investment strategies to invest in, the strategies I believe warrant particular consideration are market-neutral funds, arbitrage opportunity funds, and hedged equity funds.
Market neutral funds primarily aim to eliminate market risk by establishing both long and short positions in individual securities. These funds seek to identify and buy long positions in securities that are deemed to be undervalued from their intrinsic value, while also selling short positions in securities that are believed to be overvalued. In these funds, long equity exposure should be paired off by the corresponding short positions in the fund, netting low to zero risk as compared to the overall market. Investors in market-neutral funds benefit as securities move toward their estimated intrinsic value.
Arbitrage opportunity funds seek to exploit temporary security mispricing or identify undervalued securities that may be in an event-driven situation. There are countless strategies fund managers look for when identifying arbitrage opportunities, from price differences caused by a security that trades on a foreign exchange due to currency changes, to price differences from an announced merger, or even a convertible bond security that is undervalued to its conversion value. If there is a price inefficiency where a risk-free profit can be made, fund managers will exploit the opportunity until the price is back to the security’s intrinsic value. Arbitrage opportunity funds should be able to generate positive returns in all types of market environments.
Unlike the previous strategy, hedged equity strategies are designed to provide downside protection during a market correction, while at the same time participating in equity upside in a trending upmarket. Lowering volatility is the ultimate goal when investing in hedged equity funds. Hedged strategies seek to achieve their objectives by investing in a diversified portfolio of equities, while tactically writing call options against individual positions inside the fund or writing options against an index to collect option premiums. To hedge against downside risk, these funds will purchase put options (the right to sell a security at a specified price on a set date) on individual securities or against an index. During market downturns, losses within the portfolio are offset to some degree by the increase in value of the put options. These funds are not intended to eliminate total market risk, but rather are designed to reduce it.
Considering where we are in the current market cycle, investors should be exploring non-traditional investment strategies that can help mitigate risk. Safe haven investments in U.S. Treasury and defensive sectors of the stock market have already attracted a significant amount of capital and in my opinion have become expensive. Therefore, alternative investments are an area that should be considered for inclusion in investors’ portfolios. As always, before doing so, you should first contact your investment professional to discuss how alternative investment strategies could benefit your overall investment strategy.
1Bloomberg L.P. 30-Year U.S. Treasury graph 1/1/1979 to 9/1/2019. Bloomberg terminal. September 18, 2019.
2Bloomberg L.P. 10-Year S&P 500 Index graph 9/19/2009 to 9/18/2019. Bloomberg terminal. September 18, 2019.