- Expect lower equity returns, increased volatility and rising interest rates in 2019.
- Alternative investments can help investors weather a more challenging environment.
- Investors need to be proactive and avoid the mistake of adding alternatives reactively.
Following an idyllic 2017, when equity markets were characterized by strong returns and low volatility, we were reminded in 2018 that markets are often volatile and can go down just as easily as up. In 2019, I believe investors should be preparing themselves for lower equity returns, increased volatility and rising interest rates. Given this outlook, investors would be well-served (in my opinion) to consider the addition of alternative investments to their portfolios.
What are alternative investments?
Invesco defines alternatives as investments other than publicly traded, long-only equities and fixed income. Based on this view, investments that have any of the following characteristics would be defined as alternative investments:
- Investments that engage in “shorting” (i.e., seeking to profit from a decline in the value of an asset), such as global macro, market neutral and long/short equity strategies.
- Investments in asset classes other than stocks and bonds, such as commodities, natural resources (i.e. timberland, oil wells), infrastructure, master limited partnerships and real estate.
- Investments in illiquid and/or privately traded assets, such as private equity, venture capital and private credit.
Historically, alternative investments were only available for institutional and ultra-high net worth investors, but that is no longer the case. Many alternative investment strategies are currently available to all investors through various investment vehicles.
Alternatives to consider for 2019
Given my outlook for lower equity returns, increased volatility and rising interest rates in 2019, investors may want to consider the following types of alternative strategies available as mutual funds:
- Global macro for opportunistic, long/short investing across global markets. Global macro funds invest opportunistically on a long and short basis across global equity, fixed income, currency and commodity markets. Because these funds can invest long and short, there is a potential for investors to earn profits in both rising and falling market environments. For this reason, global macro funds have the potential to outperform traditional stocks, especially during challenging and volatile periods for equity performance.
- Market neutral to help preserve principal. Market neutral funds trade related equities on a long and short basis, such that the funds have close to zero net market exposure. In these funds, the key to generating a positive return is security selection — determining which equities to go long and which to go short. Given the lack of net market exposure, market neutral funds tend to reduce the impact of market swings, have the potential to generate positive returns in all market environments, and may produce returns that have low correlation to equities and bonds.
- Long/short equity for potential upside equity market participation coupled with downside risk mitigation. Long/short equity funds combine both long and short equity positions in a portfolio, while typically being net long to equities. As a result, performance tends to directionally follow the equity market. However, the short positions have the potential to cushion performance during periods of stock market decline.
- Senior loans to play offense in a rising interest rate environment. Senior loans (also known as bank loans) are made by banks to non-investment grade companies, commonly in relation to leveraged buyouts, mergers and acquisitions. The loans are called “senior” because they are contractually senior to other debt and equity and are typically secured by collateral. Because the loans are made to non-investment grade companies, the associated coupons tend to be higher than on investment grade corporate bonds. Another key aspect of senior loans — the interest rate typically floats with a reset every 30 to 90 days. This means that in a rising rate environment, as long as the rate rises above a predetermined minimum level, investors may benefit by receiving increased payments from the borrower.
- Multi–alternatives may offer a one-stop shop investment in alternatives. Multi-alternative funds generally invest across multiple alternative strategies and/or alternative managers. These typically use a combination of alternative strategies, including taking long and short positions in debt and/or equity, alternative assets and futures, among others. Such funds may provide investors with broad exposure to alternatives via a single fund.
A final word
One final word on alternatives: In my opinion, the most common mistake investors make with alternatives is investing on a reactive basis, seeking out alternatives following a period of outperformance by these assets. For this reason, I encourage investors to research and consider an appropriate allocation to alternatives, especially given the current market environment.