Financial advisors and investors are looking warily at 2015. By most indications, they can expect to see interest rates start to rise later this year, potentially pushing fixed-income returns into negative territory. With the Federal Reserve no longer being patient about its need to raise short-term interest rates, should investors become more proactive in adjusting their investment portfolios and, if so, how?

Traditional asset classes, stocks and bonds, are facing the strongest headwinds since the end of the global financial crisis. The end of quantitative easing and the start of the normalization of monetary policy have helped strengthen the dollar, which mechanically lowers the value of foreign-earned profits for businesses and investors. All that is a way to say that the U.S. stock market is less likely to produce the strong gains that were seen over the past four years. Additionally, it’s not unreasonable to expect that the rise in volatility we saw in the fourth quarter of 2014 will continue throughout 2015.

Fixed-income investors will most likely finally see an increase in rates at the short end of the curve, which could have implications for the broader bond markets. While few strategists are expecting an aggressive move up in rates across the curve, rising rates will act as a headwind for the total return of the bond markets; in a best-case scenario, investors should not expect returns beyond the coupons, and in many parts of the fixed-income market, they may also face some principal erosion. Rising interest rates and a less robust economic outlook could also cause the spread between government bonds and nongovernment bonds, such as mortgages, investment-grade corporates, and possibly parts of the non-investment-grade space, to widen (meaning that investors will demand a higher return for taking credit risk, though the junk bond universe may have already corrected in terms of spreads), which could also lower expected returns for diversified fixed-income portfolios.

What are the alternatives?

Investors may want to consider diversifying their traditional portfolios by adding nontraditional investment strategies, or alternative strategies that have greater investment flexibility versus traditional asset classes.

Alternative strategies are growing in popularity as a viable alternative to stock and bond holdings in a well-structured investment portfolio. Asset allocators can mitigate a portion of portfolio risks by incorporating one or more alternative strategies together into a single alternative fund to add more diversity than if a single alternative strategy was selected. For example, the Wells Fargo Advantage Alternative Strategies Fund includes four different alternative strategies: equity hedged, event driven, global macro, and relative value. Equity hedged and event driven strategies typically have the ability to sell stocks short, which creates an additional avenue to add value. Global macro strategies benefit from rising volatility and falling correlations across a variety of markets.

The goal of including alternative strategies in a portfolio during a time of rising interest rates is to improve the efficient frontier (the risk/return profile of the investment opportunity set available to investors) by providing a substitute for the portfolio ballast—the role that bonds have historically played.

The chart below illustrates how strategies with allocations to alternative strategies behaved during a similar period of volatility and rising interest rates from 2003 to 2007, during which time rates increased by three percentage points. If investors had pivoted to a diversified mix of alternative investments, their results would have improved, as alternatives outperformed bonds during that period—a diversified portfolio of Multi Alts Strategic Allocation returned 10.8 percent on an annualized basis versus a 3.9 percent annualized return for the Barclays U.S. Aggregate Bond Index. Adding alternatives during that period improved the efficient frontier, reducing portfolio volatility from 6.02 percent to 5.67 percent. Stocks performed very well during this period, which is why the traditional portfolio (comprised of stocks, bonds and cash without alternatives) outperformed. The impact could be more dramatic if rates spike over a shorter period as they did from October 1998 to March 2000, when Barclays U.S. Aggregate Bond Index gained just 1.1 percent versus 30.1 percent for alternative strategies.

 

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