This fall has been a challenging season for equities. In October, the S&P 500 Index declined approximately 9%,1 while volatility, as represented by the VIX Index, more than doubled.1 And November hasn’t been much better, with some stock indexes approaching double-digit losses for the year as we enter December.2 This behavior serves as yet another reminder that equity markets are often volatile and can go down just as easily as they can go up. Given this recent and vivid demonstration, I believe investors (and their portfolios) should consider the potential benefits of allocating to alternatives.
Uncertainty breeds volatility
This reminder is very timely, given that the current US bull market, already the longest in history, is approaching its 10th year. Importantly, I believe investors should be preparing for a more challenging environment going forward; namely, an environment characterized by lower equity returns and increased volatility. Just consider all the currently “pending” events (Brexit, Iran, mid-term election fallout, North Korea, the caravan, etc.) — any of these could potentially move markets. By preparing their portfolios proactively, investors may avoid the common mistake of investing reactively and after the fact.
I believe alternatives offer far greater flexibility in their investment strategies than traditional equity and fixed income investments. Portfolio managers using alternatives can invest on both a long and short basis, and can invest across multiple asset classes. As a result, they have the potential to generate returns that are unique and can be uncorrelated to those of traditional equity and fixed income investments.
Understanding different alternative strategies
Everyone’s investment objectives are different, but for many, limiting downside risk through diversification is a common goal. In preparing for what I believe to be a more challenging market environment, investors may wish to consider the following types of alternative strategies, all of which can be accessed via mutual funds:
- Global macro for opportunistic, long/short investing across the global markets. Global macro funds invest opportunistically on a long and short basis across global equity, fixed income, currency and commodity markets. These funds have the ability to select what markets to participate in, and, because they can invest on both a long and short basis, they have the potential to generate profits in both rising and falling market environments. For this reason, they have the potential to outperform equities, especially during periods of heightened market volatility.
- Market neutral to help preserve principal. Market neutral funds trade related equities on a long and short basis — the goal of the fund is to maintain a close-to-zero beta and 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 beta and net market exposure, these funds try to reduce the impact of market swings, have the potential to generate positive returns in all market environments, and typically produce returns that have low correlation to equities and bonds.
- Long/short equity for potential upside equity market participation coupled with downside protection. 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. However, the short positions have the potential to cushion performance during periods of stock market decline.
- Senior loans to play offense in a rising interest rate environment. Senior loans (also known as bank loans) are made by banks to non-investment grade companies, commonly in relation to leveraged buyouts, mergers and acquisitions. The loans are called “senior” because they are contractually senior to other debt and equity, and are typically secured by collateral. Because the loans are made to non-investment grade companies, the coupons tend to be higher than on investment grade corporate bonds. Another key aspect of senior loans — the interest rate typically floats with a reset every 30 to 90 days. This means that in a rising interest rate environment, as long as the rate rises above a predetermined minimum level, investors may benefit by receiving increased payments from the borrower.
- Alternative assets to protect against inflation. Alternative assets (also known as real assets) are investments in asset classes other than stocks and bonds. Real estate, real estate investment trusts (REITs), commodities, natural resources, infrastructure and master limited partnerships are all examples of alternative assets. These have historically increased in value during periods of inflation, and for this reason, can potentially help a portfolio during inflationary periods. For example, according to a study by Investment News, leveraged loan and real estate income investments (like REITs) outperformed the consumer price index 79% and 71% of the time (respectively) in the period from 1973 through 2012.3
- Multi–alternative may offer a one-stop shop investment in alternatives. Multi-alternative funds are funds that invest across multiple alternative strategies and/or alternative managers. These typically use a combination of alternative strategies, including taking long and short positions in debt and/or equity, alternative assets and futures, among others. Such funds can provide investors with broad exposure to alternatives via a single fund.
To learn more about Invesco and our alternative investment options, please visit invesco.com/alternatives.
1 Source Bloomberg L.P., as of Oct. 29, 2018
2 Source Bloomberg L.P., as of Nov. 27, 2018
3 Source: Investmentnews.com, “How nine asset classes fare against inflation,” Jason Kephart; based on annual data from 1973 through 2012
Blog header image: George Dolgikh/Shutterstock.com
The CBOE Volatility Index® (the VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility.
Beta is a measure of risk representing how a security is expected to respond to general market movements.
Correlation is the degree to which two investments have historically moved in relation to each other.
Long positions are buying a security with the expectation that it will increase in value.
Net market exposure is the percentage difference between a fund’s long and short exposure.
Short positions/short selling is the sale of a security not owned by the seller, then buying later. The belief is that security prices will decline and the price paid to buy it back at will be lower than the price it was sold.
Long/short strategies (equity or credit) typically take both long and short positions to benefit from rising prices on the long side and declining prices on the short side.
Diversification does not guarantee a profit or eliminate the risk of loss.
Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.
Alternative investments can be less liquid and more volatile than traditional investments such as stocks and bonds, and often lack longer-term track records.
Alternative products typically hold more non-traditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.
Most senior loans are made to corporations with below-investment grade credit ratings and are subject to significant credit, valuation and liquidity risk. The value of the collateral securing a loan may not be sufficient to cover the amount owed, may be found invalid or may be used to pay other outstanding obligations of the borrower under applicable law. There is also the risk that the collateral may be difficult to liquidate, or that a majority of the collateral may be illiquid.
Short selling is a speculative investment and may require investors to meet margin requirements and repurchase the security at a higher price, causing a loss. As there is no limit on how much the price of the security can increase, loss potential is unlimited.
A real estate investment trust (REIT) is a closed-end investment company that owns income-producing real estate.
Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.
Most master limited partnerships (MLPs) operate in the energy sector and are subject to the risks generally applicable to companies in that sector, including commodity pricing risk, supply and demand risk, depletion risk and exploration risk. MLPs are also subject to the risk that regulatory or legislative changes could eliminate the tax benefits enjoyed by MLPs, which could have a negative impact on the after-tax income available for distribution by the MLPs and/or the value of the portfolio’s investments.
Although the characteristics of MLPs closely resemble a traditional limited partnership, a major difference is that MLPs may trade on a public exchange or in the over-the-counter market. Although this provides a certain amount of liquidity, MLP interests may be less liquid and subject to more abrupt or erratic price movements than conventional publicly traded securities. The risks of investing in an MLP are similar to those of investing in a partnership and include more flexible governance structures, which could result in less protection for investors than investments in a corporation. MLPs are generally considered interest-rate-sensitive investments. During periods of interest rate volatility, these investments may not provide attractive returns.
Alternatives Investment Strategist
As Alternatives Investment Strategist, Walter Davis serves as Invesco’s primary alternatives representative to retail, high net worth and institutional clients across the major broker dealers, wirehouses and RIAs. He is responsible for collaborating across Invesco’s alternative strategies to develop a cohesive alternatives education program for financial advisors and investors.
Prior to joining Invesco in 2014, Mr. Davis served as a managing director in Morgan Stanley’s Alternative Investments Department, and earlier as director of High Net Worth and Institutional Sales. Prior to Morgan Stanley, he worked at Chase Manhattan Bank in the Alternative Investments Department. He has worked in the industry since 1991.
Mr. Davis graduated cum laude with a BA in economics from the University of the South. He earned an MBA in finance and international business from Columbia Business School. He holds the Series 3, 7, 24 and 63 registrations.