After a somewhat calm third quarter, October and November have been rattled by 24 changes of at least 1% up or down in the S&P 500 Index.* (For reference there was not a single 1% move up or down during the third quarter.) This uncertainty once again reminds advisors and investors that they should consider shifting their portfolios from participation mode to preservation mode.
In the quest to protect gains received by the long-running bull market, alternatives can play a valuable role in hedging equity market risk. However, with so many different alternative strategies—many of which are unfamiliar to investors—advisors need a framework for explaining the various strategies and their role to their clients.
We suggest dividing the asset class into two broad categories: alternatives that offer true diversification, and those that reduce risk, but don’t sacrifice long-term return potential.
The true diversifier camp includes alternatives with little correlation to equities. Most asset classes are highly correlated to stocks, and this has big implications during an equity market downturn. For perspective: An equally weighted portfolio of two assets with like volatilities and a correlation of 0.7 would still exhibit 92% of the volatility of either asset in isolation. True diversifiers offer much lower correlations. Below are three types of alternative strategies that fall into this camp:
- Managed Futures
- Market Neutral
Investors also need alternatives that reduce portfolio risk, but don’t overly sacrifice returns. These “risk reducers” hold up during equity market downturns, but typically outperform more traditional downside risk mitigators over longer time horizons. These alternatives can play an important role in limiting large portfolio drawdowns that may adversely affect investor psychology and behavior. In this camp, we suggest three basic strategies:
- Long/Short Equity
- Long/Short Credit
- Non-Traditional Bond Funds
In a recent article written for Investment Advisor magazine, we dive further into the strategies that make up each camp and provide digestible information on each to help your client conversations.