Alternative investments become mainstream in a low-return, high-volatility world.
It's hard to have a rosy outlook about the economy. In 2009, PIMCO popularized the term "The New Normal" to describe what the firm predicts to be a protracted period of low economic growth and high risk. Whereas not everyone agrees with Bill Gross--particularly in a recent letter where he argues that stock returns are a function of GDP growth--most investors agree that we won't see the explosive returns of the last few years, in stocks or in bonds. Even if we dampen our return expectations (GMO estimates 3.5%-6.0% real return to equities, and about 3 percentage points less for high-quality fixed income1), however, we still must come to terms with the elephant in the room: volatility. Alternative investments, particularly those offered in liquid vehicles, are a nontraditional solution to our New Normal low-return, high-volatility problem
Over the last three years, the S&P 500 index climbed 14.1% annualized, but with a whopping 15.7% annualized volatility (using monthly data). What this means is that we have experienced some major ups and downs. The problem with volatility is that it causes investors to invest poorly. Whether they are attempting to time the market or not, more volatility means investors (even professionals) are more likely to buy high and sell low.
Volatility is also a problem for the advisor community, as more and more advisors are becoming fee-based. The 2012 fi360-AdvisorOne Fiduciary Survey of broker/dealer representatives and SEC-registered investment advisors (RIAs) reported that the number of participants identifying solely as registered reps (of broker-dealers) dropped 9.9% over the last year, and less than 3% of participants reported a commission-only compensation model. Fee-based compensation means revenue is dependent on assets under management, and assets under management are largely dependent on market conditions. Unless, of course, advisors protect against volatility by diversifying their clients' portfolios into lower-correlating alternative strategies.
New Investments for the New Normal
Just how will these newfangled alternative investments serve investors in the New Normal? First, let's talk about returns. Many alternative strategies do not need stock and bond markets to go up in order to produce returns. Take managed futures, for example. These strategies bet on price trends in futures markets. Not only can these funds make money when stock and bond markets are down, but they can profit from momentum in other markets as well--namely, currency and commodities. That's why in 2008, trend-following strategies made money (8% or more) when virtually all asset classes plunged. Since 2008, trend-following or momentum strategies have seen lackluster returns, but now there are several managed-futures mutual funds that employ strategies (such as mean-reversion) to make money when the markets lack clear trends. AQR Managed Futures
Arbitrage and market-neutral equity strategies are two more options for the New Normal. These strategies make money when the prices of two similar securities (the stock of a target company and the stock of its acquisitor, for example) converge. This can happen in any kind of stock or bond market environment. The returns for unleveraged arbitrage or market neutral strategies are bondlike--a few percentage points above the risk-free rate. But unlike bonds, these strategies tend to benefit from rising interest rates (due to interest on short proceeds). JPMorgan Market Neutral
Finally, many investors fear rising interest rates--due to both a rise in real rates and increasing inflation. Currency strategies are precisely the antidote, and Merk Hard Currency
Some investors may be uncomfortable venturing into alternative strategies such as managed futures, arbitrage, and currency; they'd rather stick to stocks and bonds. The good news is that there are alternative investments out there that invest in stocks and bonds, but simply attempt to reduce the risks of these markets. Long-short equity funds, for example, take long positions in stocks but can protect against market dips by shorting stocks, exchange-traded funds, or futures, or by buying put options. The goal of long-short equity funds is to avoid most of the downside of the market but capture part of the upside, getting a better, smoother return over the long run. Marketfield
Similarly, there are funds that take long and short approaches to the bond market. The nontraditional bond category houses funds that take long credit and interest rate bets but that hedge these risks to a certain extent using instruments such as futures, interest-rate swaps, and credit-default swaps. Most of the funds in this category are too new to recommend, but Driehaus Select Credit DRSLX is one to keep an eye on. This fund largely hedges out duration risk, which will protect against losses in the event of rising interest rates.
Keeping Up With the Joneses
Institutions such as endowments and pensions have been investing in alternative investments for years. Although these institutions' investment goals are slightly different from those of the average investor, they too will suffer from a New Normal environment. Reuters reports that pensions have allocated record amounts of assets to alternative investments, about 15% for pension funds with more than $1 billion under management, in order to deal with less-than-desirable returns and high volatility.2 Although part of their alternative allocation includes illiquid investments, such as hedge funds and private equity, which the average investor cannot access, typical investors can access mutual funds or exchange-traded funds that offer them similar benefits--positive returns with low correlations. So rather than looking at the New Normal as a death sentence, investors simply have to adapt.