In an environment in which equities are near record highs and most areas of credit no longer offer compelling risk/reward profiles, many advisors are struggling with the same challenge: how to construct a portfolio that can generate an attractive return and protect capital under a variety of market environments. Alternatives can be the third leg of the stool that can help achieve both of those objectives. 

It is imperative to truly understand the underlying exposures of the alternative strategies used to make an informed decision about how a fund could behave in different environments and as part of a larger portfolio – particularly as it relates to hedging rising interest rates. A clear example of this came when “taper talk” arose initially in May-June 2013.  Credit markets reacted sharply to the news, and some strategies that have been labeled as “alternative,” such as risk parity, exacerbated the problem in many portfolios due to the embedded rate risks in this strategy.  This is why looking under the hood in liquid alternatives is critical as many very different strategies are thrown into the “alternative” bucket.  

With the looming inevitability of rising interest rates, advisors need to think about which strategies can benefit from the move and can manage the potential volatility that might ensue along the way. For example, in a rising rate environment, bonds are expected to take a hit, but under some scenarios stocks might trade off as a result of rising debt costs, while under other scenarios, stocks can perform well if rising rates indicate the economy is improving. Many nuances could make various asset classes react differently this time around, so trying to make an educated guess and market time will likely prove to be no easy feat. This is why it is important that hedge fund managers have the ability to be flexible in their positioning so that alternatives act as a diversifier to traditional equity and bond allocations and provide the significant benefit of non-correlation. 

The beauty of hedge funds is their ability to profit from market dislocations while seeking to minimize drawdowns. There are various ways to do so, whether by hedging a long portfolio or by putting on “alpha” shorts that profit from a decline in the value of stocks or bonds. As we move to a world of rising interest rates, several hedge fund strategies can potentially monetize the opportunity: long/short credit, global macro, volatility, long/short equity, as well as various relative value and arbitrage strategies. A multi-strategy fund that offers exposure to a variety of these non-correlated strategies and asset classes can potentially deliver steady performance during a period of rising rates, even if the path to higher rates is rocky. The combination of several strategies that are non-correlated to each other is a compelling approach as different environments will cater to different investment approaches. This intra-strategy non-correlation can potentially result in a steady compounding of returns with low volatility at the aggregate fund level.  At a time when advisors are looking for fixed-income alternatives, the use of a well-constructed portfolio of diversified alternative strategies could potentially provide attractive returns with bond-like volatility.

However, in order for liquid alternatives to be able to truly offer these benefits, certain structural elements need to be in place, such as the ability to execute short positions and use derivatives. In traditional hedge fund limited partnerships, this is not an issue; yet, in the rapidly expanding world of ‘40 Act liquid alternatives, a lot of shortcuts are being taken that could easily undermine the potential benefits of alternative allocations in times of market stress. Advisors need to be cognizant of this in order to be able to ascertain which ones are the best fit for their clients’ portfolios. With the proliferation of new liquid alternative strategies being offered, it is particularly important to work with a manager with expertise, years of experience, alignment of interest and a commitment to delivering style purity.

Dorothy Weaver has served as principal, chairman and CEO of Collins Capital since co-founding the firm in 1995. She served as chairman of the Federal Reserve Bank in Miami under Alan Greenspan from 1989-1994. She was recognized as one of Hedge Fund Journal’s “50 Leading Women in Hedge Funds” in 2011 and was awarded the “Industry Leadership Award” by 100 Women in Hedge Funds in 2010.