Markets rise and fall, but investors’ objectives stay the same—to grow their capital, earn income and protect against loss. The key to meeting those objectives in volatile markets is to find investments that may help cushion their portfolio should stocks decline, or that may benefit from a more challenging market environment. Alternatives, due to their unique investment approach and performance characteristics, may be the type of investment your clients need. But which alternative is right for them? That all depends on their goals.
Markets Are Becoming More Volatile
The period following the Global Financial Crisis has been characterized by accommodative monetary policy, historically low interest rates, above-average U.S. stock returns and below-average volatility. Thus far in 2018, however, a number of market warning signs are flashing, perhaps suggesting a change in the prevailing market environment.
The U.S. Federal Reserve has begun raising interest rates as they attempt to normalize monetary policy. Volatility has returned to the market as evidenced by the February market correction and the rise in the VIX volatility index. Inflations concerns have also resurfaced, and investors are concerned that both equities and fixed income could decline simultaneously.
Alternatives Can Help Investors With A Variety Of Goals
Given these warning signs, I believe financial advisors and their clients should consider these different types of alternative investments, based upon their market outlook and investment objectives:
• If looking for upside participation in a rising stock market, with potential downside protection in case of dips, consider long/short equity. Long/short equity funds combine both long and short equity positions in a portfolio, while typically being net long to equities. As a result, performance tends to directionally follow the equity market, but the short positions have the potential to cushion performance during periods of stock market decline.
• If looking for principal preservation or loss avoidance, consider market neutral. Market neutral funds trade related equities on a long and short basis, such that the fund has close to zero net market exposure. In market neutral funds, the key to generating a positive return is security selection—determining which equities to go long and which to go short. Given the lack of net market exposure, these funds tend to be insulated against market swings, have the potential to generate positive returns in all market environments, and typically produce returns that have low correlation to stocks and bonds.
• If looking to take advantage of higher volatility, consider global macro and/or managed futures. Global macro and managed futures invest opportunistically on a long and short basis across the global equity, fixed income, currency and commodity markets. These funds have the ability to select which markets they participate in, and, because they can invest on both a long and short basis, they have the potential to achieve profits in both rising and falling market environments. Furthermore, both global macro and managed futures funds have the potential to perform well during periods of heightened market volatility.
• If concerned about a return of inflation, consider real assets. Real assets such as real estate, commodities, MLPs and infrastructure have the potential to appreciate during periods of inflation.