Interest Rate Anxiety? Don’t Be Spooked

We’ve been expecting interest rates to continue to rise for quite some time as the Fed shifts away from their quantitative easing policy. However, markets have recently been spooked by Fed Chair Powell’s comments last week that “we’re a long way from neutral at this point, probably” indicating that additional rate hikes are coming. Rising interest rates can be scary, but there are some treats to be found if you look carefully.

Some alternative strategies and their investors will benefit from higher interest rates. Why? It’s all about the structural elements underlying these strategies.

Managed Futures is one such category that could benefit from rising interest rates. Managed Futures is 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 lots 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 eroded returns. This scenario has essentially robbed Managed Futures investors of higher returns. Higher interest rates would 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.

Long/Short Equity and Market Neutral could also benefit from rising interest rates because of an underlying structural component—the short rebate.

Short selling is the selling of a security that the investor doesn’t own, based on the belief that the price of the stock will decline. To affect 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 has brought uncertainty and in some cases fear, it’s nice to know that some alternative strategies—because of their underlying structural elements—can reap tangible benefits from higher interest rates and reward investors.

Read more in our article, Mind the Guardrails – They’re in Place for a Reason >