While big market swings can be unsettling to many investors, there are a number of alternative investment strategies that aim to turn volatility into opportunity, according to K2 Advisors’ Brooks Ritchey and Robert Christian. They outline some of the market challenges they see ahead, and why they believe certain hedge strategies could find fertile ground.

Today’s “risk uncertain” markets present an evolution of challenges for investors. The post-2008 massive expansion of central bank balance sheets around the developed world—one of the most dominant market-shaping forces over the last decade—is beginning to reverse. We see this in the United States and in other devel­oped economies as well. Markets have seen increased volatility and threat of increased inflation. Earnings growth looks like it may be slowing somewhat. In addition, macroeconomic concerns—including geopolitical hot spots, growing political uncertainty in Europe and the threat of trade wars—all pose legitimate concerns for market stability.

In particular, the recent drawdowns in equity markets may be especially concerning. These declines are happening in the face of rising interest rates. Historically, if investors sought to manage equity volatility, they could do so by using core fixed income. Now, overweight in core fixed income carries its own risk, because of heightened sensitivity to rising rates.

Bottom line—investors have expressed concerns about what to do with their equity allocations, especially given current valuations and rising volatility. They are also concerned about fixed income allocations due to rising rates. These are risks they are seeking to miti­gate. We will examine some hedge strategies to illustrate why increased allocations to alternatives may be a viable approach to addressing today’s uncertain­ties.

When are They in Favor?

Opportunity set is key to alternatives. What we mean is that when there are more possible trades or investments, there is more chance of capturing alpha. Looking back over the last 25 years, there have been six periods of rising interest rates.1 We found that both the performance and standard deviation2 of long/short hedge strategies have compared favorably with stocks and bonds, and long/short hedge strategies’ volatility was comparable to bonds and nearly half that of equities.3Additionally, we have found a significant amount of performance has come from a different source than equity beta.4 In sum, we found the risk-and-return experience was better, and the ride a smoother one.

Why do we see a beneficial relationship with long/short hedge strategies, particularly in a rising interest-rate environment?

As central bank rates move higher, often we will see a wider variation of the specific interest rates that are applied to certain sectors, companies, or sovereign debt. For the vast majority of the past 10 years, as interest rates globally have been artificially suppressed, less economically sound companies or countries have been able to survive on a very low cost of financing. This was part of the central bankers’ intent as they sought to stabilize equity and bond markets.

This dynamic started to change in mid-December 2015 when the US Federal Reserve began hiking rates and, subsequently, other central banks like the Bank of Canada followed its lead. The result: a wider gap between compa­nies that have a higher debt-to-equity ratio and, say, technology firms that have a lot of cash and don’t mind if rates rise.

As a result, we have seen a higher dispersion in the performance of winning sectors versus others, such as utilities and other high debt-to-equity industries. So, the separation of performance influenced by the impact of higher interest rates creates an alpha opportunity—alpha being defined as a measure a manager’s value added relative to a passive strategy, independent of the market movement.

In addition to the impact from rates on equity and fixed income, higher volatility in the major currency markets of the world also has an impact on sectors in terms of revenue growth, and whether they are importers or exporters.