ETF analyst Tim Strauts explains how fixed-income alternatives could buffer your portfolio in a rising rate environment, or offer more equitylike exposure with less volatility.
Jason Stipp: I'm Jason Stipp for Morningstar. As part of Morningstar.com's Inflation Report, today we're checking in on how you might employ alternative strategies to keep ahead of inflation.
Joining me with some ideas about those strategies and some funds for further consideration is Tim Strauts. He is an ETF analyst with Morningstar. Thanks for being here, Tim.
Timothy Strauts: Glad to be here.
Stipp: So the first question for you: A lot of investors when they think about inflation, the thing that worries them the most is the fixed-income portion of their portfolio. What are some of your ideas about the tools investors could implement to help protect their fixed-income portion from the effects of inflation?
Strauts: When people talk about inflation, I think they really mean is, what's the effect of rising interest rates in my portfolio? So obviously that's going to be negative for your fixed-income portfolio.
So two alternative strategies could be: one is merger arbitrage, and merger arbitrage is basically trying to take advantage of, after merger deals are announced, the spread that's available on stocks.
So, for example, if Google announces they're going to buy out a smaller firm, they may announce that they're going to buy out the firm for $40 a share. Until that merger is completed, the stock price--you don't get your $40 a share. So the stock price will probably rise to somewhere around say, $39.50. On a merger arbitrage strategy you can buy the stock for $39.50 and wait until you get your $40, so you can cut that $0.50 premium. And you do that over many, many mergers to diversify your portfolio. So it's a way to get a little extra return out of these spreads.
Stipp: So that little bit that doesn't go all the way to $40, that's just in case for some reason the merger doesn't go through, right? There is a little bit of discount due to the uncertainty there.
Strauts: Yes. That's the risk is that Google has antitrust issues and can't get the deal through, and then the [addition target's] stock is going to fall back down, so that's what you pay for the risk.
Now if you spread that risk along 50 different mergers or 100 different mergers, it's not that much risk, and the returns you get on merger arbitrage are similar to fixed income, and actually the spread, the size of that spread is related to short-term interest rates. So if we're in a rising interest rate environment, the spread should be wider, meaning you can make more profits in merger arbitrage.
So the two funds we like in that category in the mutual fund space is Merger MERFX, and in the ETF space it'd be Credit Suisse Merger Arbitrage ETN and the ticker is CSMA.
Now the other category we also look at is market neutral. Now market neutral is the idea that you want to eliminate the market effects from your portfolio. So what a typical strategy will do is go 100% long in stocks and 100% short in stocks, so you're net zero exposure to the market, and the returns there are just that year longs do better than your shorts. Again, the returns can be similar to fixed income and really a good diversifier there.
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Stipp: So, couple of possibilities. Do you have some funds in market neutral that you guys have taken a look at and you might recommend investors look further into?
Strauts: Sure, that would be JPMorgan Research Market Neutral, ticker JPMNX, and in the ETF space, ProShares RAFI Long/Short, ticker RALS.
Stipp: So these are a couple of options that investors might use maybe as a sleeve of their fixed-income portion, maybe something that they would add on potentially at the margin just to offer a little bit of protection there.
What about the stock side? Now, some investors will say that stocks just in and of themselves will protect you against inflation. Do you agree with that? Do you think that just holding stocks will get you ahead of inflation in the longer term?
Strauts: Well, stocks do offer some inflation protection, but usually what you see is that you get a very volatile stock experience. You can get very volatile markets.
Look at the markets of the '70s. It was a very inflationary environment. Big swings up and down in the stock market. So, if you'd look to get a lower volatility, one thing you can look at is managed futures. Now managed futures invest in commodities and oftentimes foreign currency. Well, in an inflationary environment, you'd expect that commodity prices would be rising, so a managed futures strategy can make sense. And managed futures, how they're alternative is, they can actually go long or short the commodities. And the fund we like in that category is WisdomTree Managed Futures. It's an ETF, and the ticker is WDTI.
Stipp: Okay. And you have another strategy that potentially you could use as an alternative to your equity holdings. What would that be?
Strauts: So that could just be a regular long/short strategy and so long/short is different than market neutral in a sense that the manager will probably go 100% long and maybe only 50% short, so he is net long in his exposure. He's just not as long as your typical long-only manager. So you're still going to be correlated to the stock market, just a little lower volatility. And two funds in that area are, in the mutual fund would be Wasatch Long/Short, ticker FMLSX, and for ETF it would be Credit Suisse Long/Short and it's CSLS.
Stipp: Okay, so in this case, if you're looking to maybe augment your equity positions because you do want to stay ahead, but you're worried about that volatility, you might want to look into some of these options?
Strauts: Yes.
Stipp: Okay, so what are the things in the alternative space might investors consider if they are just sort of seeking absolute returns or looking to add something to their portfolio that they might not be getting with the traditional asset classes, which could be potentially good for inflation or other market environments?
Strauts: What you can do is you can actually buy a fund that combines a lot of these alternative strategies together. So it's in a multi-alternative category, and in that space we like Direxion Spectrum Select Alternative, ticker SFHYX, and also mutual fund Absolute Opportunities Fund, ticker AOFOX.
Stipp: All right, Tim, some interesting strategies for investors to consider and some fund ideas for them to research further. Thanks for joining me today.
Strauts: Thanks for being here.
Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.
