For U.S. equity investors, 2017 was about as good as it gets. The S&P 500 Index generated a return of 19.42 percent, posting gains in every single month of the year while avoiding any meaningful pullbacks. Furthermore, volatility, as measured by the VIX, was at historically low levels for much of the year. Thus far, the market environment in 2018 has proven significantly more difficult, and your clients may have questions about how to respond. In a time of lower returns and higher volatility, I believe absolute return strategies may offer an answer.
The Market Environment Is Uncertain
Despite being up 1.67 percent for the year, the S&P 500 experienced a correction (i.e., a decline of more than 10 percent), and now sits more than 5 percent below the all-time high it reached in January. During the year, volatility has shot higher, as evidenced by the growing number of large daily swings—most notably, a 4.10 percent daily decline that occurred in February. Furthermore, since February, the S&P 500 has been range bound, trading between 2581 and 2786.
The market outlook for the second half of the year remains uncertain, especially given the backdrop of a potential global trade war, rising interest rates in the United States, and political questions in Europe—including Brexit in the U.K. and the foggy future of Angela Merkel’s coalition government in Germany.
Investors Are Unsure How To Respond
Against this backdrop, your clients may be wondering what to do next. Do they lighten up on equities? Do they increase their allocation to fixed income, despite low rates and a rising interest rate environment? Do they go to cash? Before doing any of these things, I suggest having a discussion about alternative investments in general, and absolute return strategies in particular.
Absolute Return Strategies Have The Potential To Rise When Markets Fall
Absolute return strategies invest on both a long and short basis, and as a result, have the potential to generate a positive return in any market environment. Their long positions potentially enable them to make money when an investment rises in price, while their short positions potentially enable them to make money when an investment falls in price.
The key to their success is manager skill, namely successfully identifying what to invest in, and whether to go long or short those investments. Importantly, investors should understand that, while these managers have the tools to profit in any market environment, there is no guarantee they will successfully execute their approach and achieve positive returns.
Two Types Of Absolute Return Strategies
While there are many alternative strategies that have an absolute return objective, I would like to focus on two types, equity market neutral and global macro, which I believe have particular resonance in the current market environment.
• Play defense with equity market neutral. Equity market neutral funds seek to eliminate the impact of broad market movements by trading related stocks on a long and short basis, such that the fund has close to zero net market exposure (e.g., it is “neutral” to the market.) With these 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, this strategy can potentially be insulated against market swings, has the potential to generate positive returns in all market environments, and may typically produce returns that have low correlation to stocks and bonds. Within a portfolio, this strategy may help preserve principal, decrease risk and increase diversification. Financial advisors looking to protect client portfolios in the current market environment may consider equity market neutral funds.
• Play offense with global macro. Unlike equity market neutral strategies, global macro strategies embrace market movements as they invest opportunistically on a long and short basis across the global equity, fixed income, currency, commodity and derivative markets. These funds have the ability to select what markets they will, and will not, participate in. With these funds, the key to generating positive returns is correctly identifying which markets to invest in, and whether to be long or short those markets. Importantly, global macro has the potential to perform well during periods of heightened market volatility. Within a portfolio, the addition of global macro has the potential to help decrease risk, increase diversification and expand the opportunity set of a portfolio. Financial advisors looking to take advantage of the current volatile market environment may consider global macro funds.