When rising interest rates and inflation risks weigh on potential market returns, allocation to one alternative may not be sufficient to diversify client portfolios—but multi-alternative strategies could offer some protections.

Some market commentators are painting a putrid picture of traditional asset classes like stocks, bonds and cash. Propelled higher by market momentum, developed market stocks tend to be expensive, dampening expectations for forward returns.

Bonds, on the other hand, have been caught in a long period of low yields, and gradually rising interest rates eat away at the value of investors’ fixed-income assets.

“The house view is that client portfolios already have plenty of fixed-income risks embedded in them, so the goal of a multi-manager strategy is to diversify out that exposure by adding something different,” said Brian Murphy, portfolio manager at Vivaldi Capital Management, a Chicago-based assets manager.

Murphy, who will speak at the 9th Annual Inside Alternatives and Asset Allocation conference, running from September 24 to 25 at the Wynn Las Vegas, is on the management team for the Vivaldi Multi-Strategy Fund (OMOIX), a $73.7 million fund that allocates to four different alternatives strategies: a long-short equity strategy with no directional market exposure, a closed-end fund arbitrage relative value strategy, an announced deal merger arbitrage strategy, and an uncorrelated legacy non-agency structured credit strategy.

OMOIX offers low correlations to the S&P 500 and the Bloomberg Barclays U.S. Aggregate Bond Index. Vivaldi also selected strategies with low correlations to one another. As a result, each part of the portfolio is capable of producing mid-single digits on its own, said Murphy, with no overlapping risks.

As of August 8, OMOIX had offered investors five-year average annualized returns of 3.27 percent, according to Morningstar, and that’s after the fund’s 3.48 percent expense ratio has taken a large bite out of the fund’s potential performance.

Most multi-strategy and multi-asset alternative strategies were developed after the 2008 global financial crisis to allay investor concerns about diversification and lower returns, said Jai Jacob, managing director and portfolio manager at Lazard Asset Management.

“In high volatility, low momentum environments, multi-asset strategies are more useful,” said Jacob. “When the market is down 10 percent, multi-asset might be down 2 or 3 percent, and the power of compounding works for the investor.”

On the other hand, when markets are on a tear, as they were in 2017, multi-alternative strategies tend to underperform, said Jacob, who co-manages Lazard’s Real Assets and Pricing Opportunities strategy, which includes liquid real assets like REITs, infrastructure companies, inflation-linked bonds, commodity futures and companies affected by commodity prices and inflationary trends.

Launched in 2015, Lazard’s Real Assets and Pricing Opportunities strategy (RALIX) had offered investors three-year average annualized returns of 5.89 percent as of March 31, 2018—at that time, the strategy was nearly 60 percent equities, 24 percent fixed income, less than 14 percent commodities and less than 3 percent cash. The strategy carries a 90-basis-point expense ratio.

The rising rate environment has led Lazard to lower its allocation to real estate in its portfolio. So far, however, most of 2018’s investment themes have played into Jacob’s hands, especially as the impacts of the Tax Cuts and Jobs Act of 2017 are felt throughout financial markets.

“The tax reform had the effect of a stimulus package fairly late in the cycle,” said Jacob. “They’re increasing the debt while the economy is growing, but it’s still hard to say whether over the long term the Treasury will have to issue a lot more bonds. So far, all readings have been fairly positive since the tax reform.”

Thanks, in part, to the tax reform, Jacob’s team determined that equities were not as pricey as many investors thought they were, a view that has been supported by increased earnings in 2018.

Jacob is still concerned about trade, however.

“Trade is one of the big topics our clients are asking us about, and the reality is that any kind of capital controls on trade will impact the price of goods,” said Jacob. “It will have a pass-through effect to inflation.”

Trade wars are largely seen as a headwind for core equity and fixed income, said Murphy, but they can be beneficial to opportunistic strategies where managers can trade around spread volatility.

The trade war rhetoric also widens the dispersion in returns between companies in the same sector or geography, said Murphy.

“We’ve seen outperformance in domestic focused companies without international exposure,” he said. “We’ve also seen a wide divergence between companies within industries based on business model and sensitivity to tax rates.

“Small-cap companies have had massive tailwinds compared to large-cap multinationals, so the net result is that you’ve had a number of companies down materially in 2018 while others have been up a lot. We haven’t seen that type of dispersion on a fundamental basis in a few years.”

Investors’ reactions to rising interest rates have also helped buoy Murphy’s strategy by creating buying opportunities. Many retail investors liquidated any position that had interest rate duration, creating wide discounts in some closed-end funds.

Rising rates and fiscal stimulus have also raised the specter of another investing bogeyman: inflation.

“We’ve had inflationary head fakes in the recent past,” said Jacob. “People thought there would be inflation when quantitative easing started, but it didn’t occur. Another round thought inflation would jump right after the U.S. election and when the Trump policies were implemented, but right now there isn’t inflation priced into the yield curve.

“A multi-asset portfolio is meant to protect you from all of these issues, especially real assets and companies with pricing power. Those are good factors to own in some kind of disruption.”

Lazard’s real assets strategy is ideally intended as a liquid complement to other alternative allocations, creating a differentiated return stream that should benefit from inflation and can rebalance to smooth out the impacts of volatility.

With OMOIX, on the other hand, Vivaldi targets strategies that benefit from increased volatility by finding arbitrage opportunities. The back-and-forth nature of the rising rate environment also helps fuel Vivaldi’s strategies, said Murphy.

“It’s been an eventful first half,” he said. “We’ve increased our allocation to our relative value and our merger arbitrage book. The merger arbitrage portfolio has benefited from what seemed to be a sticky backup in interest rates; we’ve had these backups in rates a couple of times, but they haven’t really persisted for more than a few weeks or months.”