There are many environments in which investment accounts can, for the most part, succeed by using a traditional asset allocation model. This typically includes a mix of global and U.S. stocks, bonds and, perhaps, an alternative. This portfolio allocation, however, with the exception of the typically small allocation to alternative strategies, can become one of highly correlated assets, putting investors at risk if market conditions change. This was a hard lesson for many investors in 2008. Correlations are dynamic and, unfortunately, tend to increase during periods of market turmoil.
This seventh year of the bull market has presented an environment that is a stark contrast from the past two years. The uncertainty of Greece's future in the eurozone, concerns about China, the strengthening U.S. dollar, the narrowing market leadership and the Federal Reserve's intention to raise interest rates have all created an environment in which traditional asset class diversification may simply just not be enough.
In these precarious market conditions, client portfolios must include more diversification to offset risk. Portfolios can thrive when they include uncorrelated investments that can succeed despite market downturns. Alternatives play a key role in this allocation. They provide a vital diversification to a client's portfolio that can offset or even eliminate the one giant directional bet created when traditional asset class correlations increase. These alternative investments should incorporate strategies that seek to generate positive returns in any market environment, despite low correlation to the traditional indexes, to hedge against a market reversal. While there are a range of options available, there are three that deserve particular attention, given the current landscape:
(Related read: Alternatives have a chance to shine once interest rates rise)
1. Long volatility strategies
Periods of market turmoil are characterized by a significant increase in market volatility. The CBOE Volatility Index, also known as the VIX index or “fear index,” reflects a market estimate of future volatility. Investors who hope to hedge against a market downturn could benefit by taking a long VIX position through futures or an ETF that seeks to track the VIX.
The main downside to this type of strategy is the contango in the VIX futures term structure, where futures prices are more expensive than the spot price. This subjects investors to substantial negative roll yield that could rapidly deteriorate the value of a long VIX equivalent investment. One way to hedge this type of exposure is through the use of shorter-dated call options on a VIX ETF that are rolled each month. This accomplishes two objectives. First, it reduces the impact of the negative roll yield from the contango that significantly affects both long-dated call and long underlying positions. Second, it provides significant leverage to the upside (a factor of 3x to 4x is not uncommon in deteriorating markets) while limiting downside to the premium of the option.
2. Stocks with an inverse economic correlation
When stock indexes plummet, the equities market can produce some hidden gems. In fact, some stocks tend to perform at market highs during economic downturns. Retailers such as dollar stores, discount stores, pawn shops and auto parts all hold an inverse economic correlation. When the general economy takes a hit, these companies often provide value and growth. Dollar Tree, for example, was up 60.8% in 2008. Likewise, Wal-Mart was up 20% in 2008, as was Aaron's (38%) and AutoZone (16%) in the same year. A diversified portfolio of these types of stocks allows investors to maintain equity exposure while also better positioning their portfolio if conditions deteriorate.
3. Managed-futures strategies
According to Morningstar, managed-futures strategies typically take long and short positions in futures options, swaps and foreign exchange contracts. These strategies employ trend-following, price-momentum, systematic mean-reversion, discretionary global macro strategies, and commodity index tracking, among other futures strategies. The Barclay CTA Index and Newedge CTA Index, which provide a benchmark of representative performance of commodity trading advisers (CTAs), are the two most widely recognized managed-futures indices. These indices returned +14.09% and +13.07%, respectively, in 2008 versus the -37% return for the S&P 500 Total Return Index. Based on 2008 monthly returns, these indexes managed to exhibit strong negative correlations of -0.433 and -0.653 to the S&P 500 Total Return Index at a time when negative correlation to traditional asset classes would have significantly benefited most portfolios. In 2014, these indexes continued to put up solid returns. Barclay CTA Index and Newedge CTA Index returned +7.61% and +15.66%, respectively, in 2014, versus +13.69% for the S&P 500 Total Return Index.
With so much speculation filling the marketplace, it can be difficult to cut through the clutter to get a clear picture of what lies ahead. To quell the fears of uncertainty, reassessing portfolio allocation to ensure that emphasis is placed on strategies designed to ride the market waves will provide the best upside in a market that points down.
David Miller is senior portfolio manager of the Catalyst Macro Strategy Fund (MCXAX).