The recent sharp sell-off in global equity markets has focused investors on the importance of holding diversifying investments that can help mitigate volatility and potentially cushion their portfolios during times of market stress. Given their unique nature, alternative investments are proving to be useful tools to help investors weather the current market storm.
As the chart1 below illustrates, a basket of alternatives — based on Invesco’s alternatives framework as explained in my previous blog post How to approach the alternative investments puzzle — has historically delivered equity-like returns with low levels of volatility (as measured by standard deviation) and lower maximum drawdown.
Alternatives have historically helped investors manage market volatility
The period represented is January 1997 through June 2015. Past performance is not a guarantee of future results.
Bull and bear market performance
If we drill down a little further to look at alternatives’ performance during different parts of the market cycle (see the chart1 below), you can see that alternatives have historically outperformed equities during periods of equity weakness, while equities have historically outperformed alternatives during periods of equity strength. This has proven to be the case: Alternatives lagged equities during the post-crisis bull market, while they have outperformed equities on a year-to-date basis in 2015.2
Alternatives have historically outperformed during bear markets
Alternatives on the defense
Among the wide variety of alternative investments, some play offense by helping investors build wealth, while others play defense by helping preserve wealth. Given recent market events, these three types of alternatives may be appealing options for investors:
- Market neutral funds, which help cushion portfolios against market swings and mitigate downside risk. Such funds trade related3 equities on a long and short basis so that the fund’s net exposure to the market and its beta are both close to zero. The key to generating a positive return is stock selection — determining which equities to go long and which to go short. Market neutral funds seek to generate positive returns across all market cycles. Invesco All Cap Market Neutral Fund and Invesco Global Market Neutral Fund are examples of market neutral funds.
- Long/short equity funds, which hedge equity exposure while providing the potential to participate in equity market upside with the possibility for some downside protection. Allowing investors to participate in the equity markets on a hedged basis, these funds combine both long and short equity positions in a portfolio, while typically being net long to equities. As a result, fund performance often tracks that of the overall equity market, but the fund would be expected to underperform during a rising equity market (due to potential losses on the fund’s short equity positions) and outperform during a falling equity market (due to potential gains on the fund’s short equity positions). Invesco Long/Short Equity Fund and Invesco Macro Long/Short Fund are examples of long/short funds.
- Global macro funds, which invest opportunistically on a long and short basis across the global equity, fixed income, currency and commodity markets. Because they invest opportunistically, global macro funds have the ability to determine which markets they want to participate in and which to avoid. Because these funds have the ability to invest on both a long and short basis, they have the potential to achieve profits in both rising and falling market environments. Invesco Targeted Returns Fund and Invesco Global Markets Strategy Fund are examples of global macro funds.
Diversification is key in times of volatility, and alternative investments offer a variety of strategies to help investors potentially build and preserve wealth over the long term.
Read more expert views on market volatility.
1 Source: StyleADVISOR. Alternatives are represented by a portfolio comprising equal allocations to alternative assets, represented by FTSE NAREIT All Equity REIT Index, Bloomberg Commodity Index; relative value strategies, represented by BarclayHedge Equity Market Neutral Index; global investing and trading strategies, represented by BarclayHedge Global Macro Index, BarclayHedge Multi Strategy Index and BarclayHedge Currency Traders Index; alternative equity strategies, represented by BarclayHedge Long/Short Index; and alternative fixed income strategies, represented by Credit Suisse Leveraged Loan Index, HFN Fixed Income Arbitrage Index and BarclayHedge Fixed Income Arbitrage Index. The performance of individual alternative investments will differ from that of the index. Equities represented by the S&P 500 Index. Fixed Income represented by the Barclays US Aggregate Bond Index. Traditional 60/40 Portfolio represented by 60% S&P 500 Index and 40% Barclays US Aggregate Bond Index. An investment cannot be made directly in an index.
2 As of Aug. 24, 2015, every Morningstar Alternatives Fund Category is out performing the S&P 500 Index on a year-to-date basis.
3 Stocks are related if they are driven by the same fundamental factors; for example, two stocks from the same industry.
Important information
Diversification does not guarantee a profit or eliminate the risk of loss.
BarclayHedge indexes reflect performance of hedge funds, not of retail investment strategies, and are used for illustrative purposes only solely as points of reference in evaluating alternative investment strategies.
Hedge funds are typically aggressively managed portfolios of investments for high net worth investors that use advanced investment strategies such as leverage, long, short and derivative positions with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Hedge fund managers have less restriction on their investment methodologies than mutual fund managers, and hedge funds are less regulated and therefore offer less investor protection than mutual funds. Mutual funds are more transparent with regard to disclosure of underlying holdings and have lower fees than hedge funds.
The BarclayHedge Equity Market Neutral Index includes funds that attempt to exploit equity market inefficiencies and usually involves being simultaneously long and short matched equity portfolios of the same size within a country.
The BarclayHedge Global Macro Index includes funds that carry long and short positions in any of the world’s major capital or derivative markets.
The BarclayHedge Multi Strategy Index includes funds that are characterized by their ability to dynamically allocate capital among strategies falling within several traditional hedge fund disciplines.
The BarclayHedge Currency Traders Index is an equal-weighted composite of managed programs that trade currency futures and/or cash forwards in the interbank market.
The BarclayHedge Long/Short Index includes funds that employ a directional strategy involving equity-oriented investing on both the long and short sides of the market.
The BarclayHedge Fixed Income Arbitrage Index includes funds that aim to profit from price anomalies between related interest rate securities.
The FTSE NAREIT All Equity REITs Index is an unmanaged index considered representative of US REITs.
The Bloomberg Commodity Index is a broadly diversified commodity price index.
The Credit Suisse Leveraged Loan Index represents tradable, senior-secured, US-dollar-denominated, noninvestment-grade loans.
The HFN Fixed Income Arbitrage Index includes funds that attempt to exploit pricing inefficiencies between credit sensitive instruments which may include government or corporate debt, structured securities and their related derivatives.
The S&P 500® Index is an unmanaged index considered representative of the US stock market.
The Barclays US Aggregate Bond Index is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.
Stock and other equity securities values fluctuate in response to activities specific to the company as well as general market, economic and political conditions.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Alternative products typically hold more non-traditional investments and employ more complex trading strategies, including hedging and leveraging through derivatives, short selling and opportunistic strategies that change with market conditions. Investors considering alternatives should be aware of their unique characteristics and additional risks from the strategies they use. Like all investments, performance will fluctuate. You can lose money.
Diversification does not guarantee profit or eliminate the risk of loss.
Standard deviation measures a portfolio’s range of total returns and identifies the spread of a portfolio’s short-term fluctuations.
A drawdown is the largest cumulative percentage decline in net asset value as measured on a month-end basis.
Downside risk is the maximum decline based on the month-end value of an index or portfolio.
Long positions make money when an investment rises in price.
Short positions make money when an investment falls in price.
Beta is a measure of risk representing how a security is expected to respond to general market movements.
A hedge is an investment made to reduce the risk of adverse price movements in a security by taking an offsetting position in a related security.
Short sales may cause an investor to repurchase a security at a higher price, causing a loss. As there is no limit on how much the price of the security can increase, exposure to potential loss is unlimited.
