While the Federal Reserve has made its initial move on rates and future increases are anticipated, their pathway to unraveling the massive stimulus efforts is still a guessing game. Uncertainty abounds, but one thing is certain: both Wall Street and investors are anxious about higher rates. Everyone is trying to figure out what the impact will be on the investment landscape in general— and on portfolios in particular.
This is a multi-faceted problem, and rising rates may indeed result in some pain, but there are also a few bright spots. Some alternative mutual funds, Long/Short Equity and Managed Futures in particular, and their investors will be the benefactors of higher interest rates. Why? It’s all about the structural elements underlying certain categories of alternative mutual funds.
One such category of mutual funds is Managed Futures, a category of funds that tactically trade and manage futures contracts ranging from equities to interest rates to commodities to currencies. The amount of margin that must be ponied up to a prime broker when trading futures is minimal. Take for example S&P 500 futures, where the margin requirement is around 5% of the contract value.
Such low margin requirements mean that Managed Futures funds are typically sitting on piles of cash. That cash has been earning very little interest because of the prevailing low interest rate environment. Prolonged low interest rates over the past several years have been truly detrimental, especially to real returns. That’s because inflation, while still low, has exceeded short-term rates and has eroded returns. This scenario has essentially robbed Managed Futures mutual fund investors of higher returns.
“Between 1990 and 2012, the return on the cash collateral accounted for almost 50% of the return to Managed Futures strategies.”
Historically, the return on the cash collateral for Managed Futures funds has been a
significant component of total returns. In fact, in a study conducted by one of the futures brokers with whom we work closely, it was found that between 1990 and 2012, the return on the cash collateral accounted for almost 50% of the return to Managed Futures strategies.1 Higher interest rates would thus allow for these cash positions, which are currently earning next to nothing, to once again be a meaningful contributor to total return, and shareholders would benefit directly. Earning a few extra percentage points over time can really make a difference to investors’ terminal wealth.
While admittedly not nearly as impactful, increasing rates could likewise give a lift to Long/Short Equity funds, also because of an underlying structural component—the short rebate.
Short selling is the selling of a security that the investor doesn’t own, under the belief that the price of the stock will decline. In order to effect such a trade, the stock is first borrowed, and once sold, generates cash. That cash is usually held as collateral for the loan of the stock, and it can earn interest. The interest earned is shared with the borrower at some negotiated rate, say Fed Funds less 40 basis points. This is the “short rebate.”
In recent years, with short-term interest rates near zero, there hasn’t been a return on cash sufficient to offset the cost of borrowing. We’ve been in a negative rebate environment. Higher interest rates earned on cash collateral would reduce or even eliminate the cost of shorting stocks (at least for easy to borrow stocks), and beyond that, could add directly to total return. The short rebate won’t be the major driver of returns to Long/Short Equity strategies, but every bit helps, especially in a low expected return environment.
In a world where rising rates bring uncertainty and in some cases fear, it’s nice to know that Managed Futures and Long/Short Equity mutual funds—because of their underlying structural elements—can reap tangible benefits from higher interest rates and reward investors. That is a certainty.