The last few years have provided one reminder after another that volatility can return suddenly and dramatically to the markets. The banking crisis is just the latest of many that have included a worldwide pandemic, Russia’s invasion of Ukraine, and the return of near double-digit inflation.
It’s not possible for investors to anticipate everything that can go wrong, but it is possible to prepare. One way is by diversifying your portfolio using liquid alternatives, a strategy that has demonstrated the ability to dampen volatility during periods of market stress. To see how this has worked, we recently took a look at the performance of three core alternative strategies across four different stress-related market scenarios.
The categories were Multi-Strategy (as represented by BarclayHedge Multi Strategy Index), M&A (as represented by BarclayHedge Merger Arbitrage Index), and CTA (as represented by BarclayHedge CTA Index; Commodity Trading Advisor); the market conditions were Equity Stress (defined by the five largest declines in the S&P 500 Index since December 31, 2006), Rate Stress (defined by the five largest upward changes in the 10 year U.S. Treasury Bond interest rate since December 31, 2006), Credit Stress (defined by the five largest increases in credit spreads since December 31, 2006), and Equity Melt-up (defined as seven large, rapid moves up in the S&P 500 Index since December 31, 2006)*.
What we found was this: collectively these strategies provided an effective diversification tool across every period of market stress we examined, but no single strategy solved for every scenario.
In three of the four scenarios CTA was the top performer, sometimes by a lot. In times of credit stress, for example, CTA funds returned an average of 5.63% while credit broadly, as represented by the iBoxx USD Liquid Investment Grade Index Total Return (IBOXIG), was down -6.87%. In one period, May 31, 2007, through November 30, 2008, CTA funds returned 20.67% compared to a loss of --6.45%for IBOXIG. The differences were even bigger with Equity Stress, and slightly smaller with Rate Stress, but still positive.
Equity Stress Periods
Rising Rate Stress Periods
Rising Credit Spreads Stress Periods
So why not just own CTA funds? Take a look at our fourth scenario: Equity Melt Up. CTA funds lost money in two of the seven periods examined and posted an average return of just 1.52% compared to 32.33% for our benchmark, the S&P 500 Index (SPX).
Equity Market “Melt-Ups” Stress Periods
Keep in mind that melt ups, like melt downs often come out of nowhere. Based on historical returns, an investor with all his or her money in a CTA fund would quickly come to regret that decision when the markets moved higher, and over time they have moved higher more frequently than they have gone lower.
Strategy returns for Dec. 31, 2006 – March 31, 2023
Differences are the result of rounding.
Looking over a longer time period, we see that CTA would have been the worst performing strategy (2.74% annualized) with the second highest standard deviation (4.93%) and the lowest returns on a risk-adjusted basis.
While CTA may be very beneficial as a diversifier during periods of stress, other alternative strategies may also warrant consideration in the portfolio as longer-term diversifiers both to traditional asset classes and to CTA. In fact, employing a simple average of Multi-Strategy, M&A and CTA would have provided a strong hedge during the stress periods and would have had competitive returns with lower risk than any of the three individual strategies over the longer time period.
While CTAs performed very well in 2022 when there were sharp and meaningful negative trends across both stocks and bonds, in the present bank-driven turmoil – which we define as primarily equity stress – multi-strategy and merger arb funds have done well while CTA has struggled to deal with sharp trend reversals.
The bottom line: there is a clear benefit in diversifying with alternatives, especially during periods of market stress, and there is a further benefit from diversifying the diversifiers. Different alternative strategies performed differently in different scenarios, but collectively, the alternatives we examined have historically provided diversification benefits vs. traditional asset class benchmarks.
*Within each of the 4 "stress" periods, some periods are less than one year and some are greater. For comparability within each stress type, cumulative returns were used. The time period covered is 12/31/2006-3/31/2023.
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
Diversification cannot assure a profit or protect against loss in a declining market.
This material represents the opinions of its author and an assessment of the market environment at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.
The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
This material contains general information only and does not take into account an individual's financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.
Alternative investments are supplemental strategies to traditional long-only positions in stocks, bonds, and cash. Alternative investments include investments in five main categories: hedge funds, private capital, natural resources, real estate, and infrastructure.
The BarclayHedge Multi Strategy Index is a measure of the average net returns of all reporting multi-strategy funds in the Barclay Hedge database. Multi-Strategy funds are characterized by their ability to dynamically allocate capital among strategies falling within several traditional hedge fund disciplines. The use of many strategies, and the ability to reallocate capital between them in response to market opportunities, means that such funds are not easily assigned to any traditional category.
The Barclay Merger Arbitrage Index is a measure of the average net returns of all reporting merger arbitrage funds in the Barclay Hedge database. Merger Arbitrage funds typically invest simultaneously long and short in the companies involved in a merger or acquisition. Risk arbitrageurs are typically long the stock of the company being acquired and short the stock of the acquirer. By shorting the stock of the acquirer, the manager hedges out market risk, and isolates his exposure to the outcome of the announced deal.
The Barclay CTA Index is a leading industry benchmark of representative performance of commodity trading advisors. There are currently 412 programs included in the calculation of the Barclay CTA Index for 2023. The Index is equally weighted and rebalanced at the beginning of each year.
The S&P 500® Index is widely regarded as the standard index for measuring large-cap U.S. stock market performance.
iBoxx USD Liquid Investment Grade Total Return Index measures the USD denominated, investment grade, corporate bond market.
Standard Deviation measures how widely dispersed an indexes returns have been over a specified period of time. A high standard deviation indicates that the range is wide, implying greater potential for volatility.
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