Liquid alternative investments are increasingly becoming the answer for investors who want to achieve greater diversification, reduce volatility, preserve capital and generate income. Although not meant to replace core holdings, liquid alternatives can provide smaller investors the chance to benefit from investment approaches that were previously only available to institutions. The choices among liquid alternatives are many, however. Advisors can add value for clients by understanding various strategies and determining when they are appropriate for client portfolios. The following commentaries from leading liquid alternative fund managers provide insight on many popular strategies.
Alexander D. Healy, Ph.D.,
Director of Strategic Research and Portfolio Manager,
AlphaSimplex Group, LLC
Market Volatility Has Implications For Investors
Market volatility, as measured by the VIX, was relatively low for the first three quarters of 2014. Yet, as we saw in October, things can change quickly. The volatility of volatility, or how rapidly volatility changes over time, has increased in recent years and this has implications for investors.
First, a broader view of risk is essential. As of September 30, AlphaSimplex Group’s measure of U.S. market risk, the Downside Risk Index (DRI),* was below average at 41 (out of 100). However, when we analyzed global markets, the story was different: European market risk appeared above average at 81. Given that global markets tend to be highly correlated, this large dispersion suggested one of two things was likely: either risk in the U.S. would rise, or risk outside of the U.S. would fall. Either way, investors need a broader view of risk.
Second, investors need to prepare their portfolios for sudden changes in volatility by allocating to truly diversifying strategies. Our research into market behavior suggests investors make poor decisions in times of stress because they are influenced by emotions. As a result, investors are looking for ways to construct more durable investment portfolios that take into account the risk of rapidly changing market conditions. For example, some are adding liquid alternative strategies with low correlation to stocks and bonds, such as trend-following strategies like managed futures.
Third, investors should consider products that systematically factor in changes in risk and volatility—so that they don’t have to. We believe markets are adaptive and volatility is not a constant. While AlphaSimplex does not attempt to predict future volatility shifts or macro events, we extensively research and analyze market behavior and risk. Based on these insights, we build products that systematically adjust to changing volatility and risk, removing emotion from the process.
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For more information visit www.alphasimplex.com.
Scott Schweighauser,
Partner, President and Portfolio Manager,
Aurora Investment Management LLC
Favorable Opportunity Set For Hedge Funds
In the face of anemic bond returns, stock market uncertainty, and the prospect of higher interest rates, generating an attractive long-term portfolio rate of return has once again become challenging. Dynamic and diversifying hedge fund strategies—which historically have exhibited low correlation to traditional markets and provided downside protection during declining markets—can offer investors more ways to “win” through the ability to go long and short, while mitigating market volatility and portfolio sensitivity to broad market risk factors.
Market conditions for hedge fund strategies are favorable today. The retreat of macroeconomic factors as drivers of markets and security values has fostered an investment environment that can reward successful security selection, both long and short. Declining levels of intra-stock correlation and increased dispersion within certain sectors has led to increased alpha opportunities for equity-based, fundamentally-oriented strategies such as long/short equities.
Rising rate environments can also create opportunities for hedge funds. A hedge fund manager can use dynamic trading strategies to capitalize on market dislocations while actively managing exposure to interest rate-sensitive segments of the market. Rising rates lead to higher borrowing costs, providing an additional tailwind for security selection strategies. Today’s active corporate event environment also favors activist and event-driven managers.
Ensuring exposure to the most talented and competent managers practicing these strategies requires significant resources, infrastructure and expertise. By investing through an actively monitored and dynamically allocated portfolio of hedge funds, an investor can access multiple high-quality managers in diverse strategies. A hedge fund allocator can also tactically adjust strategy allocations and exposures to underlying hedge fund managers to emphasize those best suited for a particular market environment and take advantage of investment opportunities.
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For more information visit www.aurorallc.com.
Michael T. Buckius, CFA,
CIO, Senior Vice President and Portfolio Manager,
Gateway Investment Advisers, LLC
Higher SKEW May Indicate Investor Preference For Index Options
The options market is signaling nervousness. According to the Chicago Board of Exchange SKEW Index (“the SKEW”), recent expectations of large losses in the equity market are about double the normal level. The CBOE SKEW Index uses S&P 500® Index options pricing to determine how much investors are willing to pay for protection from a negative outlier return. A higher SKEW reading indicates the option market has priced in a higher probability of a negative “tail event,” or a return that would fall in the extreme left tail of a distribution of monthly returns for the S&P 500 Index. Current SKEW Index levels are high by historical comparisons and the indicator has been above average for over a year.
Is this market environment potentially one of the most risky in the last 25 years? While the list making investors nervous is lengthy—including slowing economies in Europe and China, geopolitical tensions in the Ukraine and the Middle East, democracy protests in Hong Kong, the global spread of the Ebola virus, and changes to developed market monetary policies—the risks are hardly unprecedented in terms of the market’s tolerance.
Rather than extreme nervousness, SKEW may indicate investor preference for index options as a source of downside protection over more traditional sources such as long positions in U.S. Treasuries and short positions in the equity market. Investors may be hesitant to short equities because of the persistence of the market’s advance and remain wary of high-quality fixed-income instruments due to historically low interest rates.
Investors seeking downside protection may find low-volatility equity strategies appealing. These strategies can offer exposure to potential downside protection by using index put options, but may also help manage the cost of that protection through strategies that fund put option buying with call option selling. Such strategies may allow investors to participate in market advances while providing downside protection during short-term, severe market declines.
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For more information visit www.gia.com.
Matthew J. Eagan, CFA,
Portfolio Manager,
Loomis, Sayles & Company, LP
Seeking To Limit Volatility In A Challenging Global Bond Market
Currently we continue to temper our assessment of the rate environment. We believe the 10-year U.S. Treasury will reach 3.25% by the third quarter of 2015, but we do not believe rates will go much higher. Longer term, the picture for Fed interest rate policy has become more “hawkish.” Further, there is potential for increased rate volatility as the market digests the date and pace of future rate hikes.
We believe credit spreads are tight and expensive, and they may stay that way for a while given strong investor demand for new issues and general yield-seeking behavior. The global bond market remains challenging, as desynchronized recoveries among major economies may protract the global economic recovery and keep inflation low.
Within emerging markets, we believe overall fundamentals remain relatively sound. However, some countries, such as Brazil, may face slower growth, which, if prolonged, may reverse recent improvements. Better growth in the developed world should be a positive factor for emerging markets. Recent actions from the European Central Bank (ECB) on enhanced liquidity in the euro zone may provide support to the higher-yielding emerging markets.
We expect the strong U.S. dollar to continue given the U.S. economy’s relative health. We are moderately positive on the Norwegian krone due to its recent underperformance versus other developed market currencies. We have a less favorable view of the euro and yen, as the ECB and Bank of Japan maintain efforts to reflate their economies and ease monetary conditions.
We believe non-traditional absolute-return-oriented strategies may serve as an effective replacement for or complement to traditional core fixed-income strategies, introducing similar return and volatility targets while broadening the investable universe. These strategies allow managers the flexibility to opportunistically venture away from benchmarks and typically emphasize the risk side of the risk-return relationship, seeking to actively mitigate downside and limit volatility.
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For more information visit www.loomissayles.com.
Steven Brod,
CEO,
Crystal Capital Partners
Stand Out With A Quality Alternative
With over 20 years of experience, Crystal Capital has witnessed firsthand the development of a $2.7 trillion industry that is growing and has increasingly become an important component of the institutional investors’ asset allocation. Institutional investors, such as pensions, endowments, foundations, and sovereign wealth funds, are generally afforded the advantage of size and unlimited resources, which offers access to top-tier managers and the ability to construct a portfolio that is uniquely tailored to their own goals and objectives. We are largely focused on democratizing the hedge fund investing landscape as our motivation today is to provide independent advisors and other financial intermediaries the ability to customize their own hedge fund program in a similar manner to the endowment model.
Since launching our Customized Hedge Fund Portfolio Solution in 2009, advisors were presented with the opportunity to stand out with a quality offering. With our service, they can construct a customized hedge fund portfolio for their qualified investors by accessing 75+ institutional-quality funds without the prohibitive minimum investments and operational complexities generally required. In 2014, with the goal of continuing to level the playing field, we launched our Customized Strategy Hedge Fund Portfolio Solution with the intention of bringing customized hedge fund investing to accredited investors.
Through our comprehensive service, advisors have the opportunity to grow their business and provide their clients with a customized solution that includes exposure to institutional-quality hedge funds that have historically been reserved for the most sophisticated investors.
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For more information visit www.crystalfunds.com.