This year’s spike in volatility provided a terrific opportunity to judge the effectiveness of liquid alt mutual funds. For clients who have become increasingly concerned with the direction of global markets, this review may be a timely means of positioning their portfolio, as well.
Clients might be forgiven for being caught off-guard by stock market jitters: The Dow hovered between 17,500 and almost 18,300 from February to August — in percentage terms, it was the narrowest six-month range since 1926.
But the third week of August saw global markets plunge as news about China’s slowdown caused many investors to hit the panic button. On Aug. 24, the Dow opened with a 1,089-point nosedive and the S&P 500 was pushed into correction territory. Panic buying also sent yields on benchmark 10-year Treasuries to a four-month low of 2.0%.
Such volatile conditions are precisely why clients include liquid alts as part of their wealth planning. Certainly not all products behave identically, but, at least at the strategy or fund-classification level, we can examine average performance to judge how well they’ve handled this latest bout of wild market activity.
For this study, we looked at 50-day performance over four periods, corresponding to the month-end of the past four months (50 days to June 30, 50 days to July 31, etc.). The choice of 50-day periods is arbitrary. In addition, we only considered mutual funds for inclusion. While there are some actively managed alternative ETFs, clients have chosen mutual funds by a wide margin.
Among the 11 liquid alts mutual fund strategies tracked at Lipper, all but one group (short bias) showed greater volatility (as measured by standard deviation) than the S&P 500 at all four points we measured.
For perspective, the S&P 500 had an annualized standard deviation of 26.0% at the end of September, while that of short-bias funds was more than 40.3%.
Another volatile group, Alternative Active Extension — the home of 130/30 funds — showed roughly the same standard deviation as the equity benchmark over all periods.
From there, volatility tended to decline in line with strategies less reliant on equities, with the lowest volatility recorded by alternative credit-focus funds (popularly called unconstrained bond funds).
The ACF group’s standard deviation barely budged, rising to 3.3% from 2.3%, and its average return remained fairly steady.
HEAVIER STOCK ALLOCATIONS
These results agree with traditional views of portfolio risk, where heavier stock allocations provide more volatility. In fact, in a simple 60% stock/40% bond portfolio, over the past 10 years, that portfolio would have had 98% of the volatility of an all-stock portfolio.
Under that split, bonds often provide limited opportunities to meaningfully reduce volatility, which is where alts typically come into the conversation.
So far, no great surprises. But what happens when we test the ability of alt funds to add diversification benefit for two clients: one who holds a lot of equity (for argument’s sake, 100% S&P 500) and the other who holds fixed income (using 100% Barclays Aggregate)?
One of the unfortunate surprises many clients endured during the 2008 financial crisis was correlation singularity, where many different assets transmit volatility to each other and bring correlations among diverse assets near 1. Did alt funds maintain their desired low correlations during the recent tumult?
The short answer is, results were mixed. The average 130/30-style fund, for example, saw its correlation with the S&P 500 increase from 0.89 to 0.96 at the end of September.
As supposed diversifiers, these funds went from bad to worse. Long-short equity and event-driven each saw their stock market correlation climb slightly this summer to 0.81 and 0.79, respectively, and neither proved a worthy diversifier.
Two other strategies (multi-strategy and global macro) provided mild diversification for equity-intense clients; their correlations hovered between 66% and 74% throughout the tumult.
Clients in absolute-return funds were treated to declining equity correlation heading into the end of September; the average fund in this category saw its correlation drop to 53% from 59%. Nothing stunning, but helpful nonetheless.
Currency strategies funds began with low correlations (an average of 27%) but trended higher to 42% at the end of September.
More-consistent results were found among equity-market-neutral and credit-focus-alternative products, where 50-day correlation with the S&P 500 remained well within a “low correlation” range of 32% to 37%.
As expected, short-bias (or bear market) funds provided negative correlations throughout all periods, from -66% to -74%. However, because these figures are on the other side of a -70% correlation, they provide better hedging than true diversification.
In fact, the real stars of this test were managed-futures products. This group began the low-volatility period with an average equity correlation of 36%, then dropped to -24% by the end of the study.
Up to July 31, their average correlation sat at a near perfectly non-correlated -1% — exactly the direction one would hope for when markets turned squirrely.
To this point, we’ve only considered correlations with a pure equity portfolio (actually, just the S&P 500). What about an investor with a bond-centric portfolio — or, in this case, the Barclays U.S. Aggregate index?
The good news here is that just about all alternatives products provide very good (almost exceptional) diversification benefits to a bond portfolio.
All 11 group averages had a correlation to the bond benchmark between -43% and +28% at the start of the study. Even though figures showed climbing correlation with the benchmark by the end of July, we still saw correlations between -51% and +35%.
Over the following two periods, correlations improved (got closer to zero) in most cases, save for managed-futures funds, which further widened to a 35% correlation — a figure that could still be considered low correlation.
With respect to correlations against an equity benchmark, the diversification benefit for fixed income is readily available in nearly all products, and provided consistent diversification in spite of the market turmoil.
In fact, it’s probably clear to many users of alternatives products that they are sold as an alternative to equity-heavy portfolios, but it’s the fixed-income client that obtains the most reliable diversification benefit.
That said, structuring a traditional equity and bond portfolio to also include alternatives will almost certainly reduce volatility, regardless of the type of product chosen.
This comes with the caveat that equity-heavy clients need to be more choosy about the type of product involved than do bond-heavy investors. Some “alternatives” simply don’t live up to their name.
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