In a prolonged bull market environment where pullbacks are a greater concern, investors can consider ETFs that track liquid alternative investment strategies to build better portfolios and to mitigate downside exposure in case of sudden risk-off events.
On the recent webcast, Preparing for Down Market Conditions with Alternative Strategies, Salvatore Bruno, Chief Investment Officer and Managing Director at IndexIQ, outlined a number of worrying signs that investors are facing today. For example equities have risen substantially over the past 10 years. Rates are slightly higher than historic lows. Currencies have been range-bound since 2014, after a run-up in the US Dollar. Valuation metrics are relatively high to historic averages. Furthermore, we still have to digest potential tariff implications and rising Fed rates.
“Can the Financial Crisis happen again? Sure, but will the same risks come into play in the same order? Likely not. This is why a mix of non-traditional risks is an important piece of diversification,” Bruno said.
For example, Bruno pointed to hedge fund-esque strategies like long-short and event-driven, among others, as a way for investors to benefit from stress period persistence and risk diversification.
In a highly correlated global market, investors should consider strategies that offer lower correlations or do not follow the movements of traditional stocks and bonds. The MSCI EAFE Index exhibited a 0.92 correlation to the S&P 500 from 2007 to 2009, compared to a 0.47 correlation back in 1980 to 1990 – a 1 reading corresponds with a perfect, lock-step correlation.
“Intertwined global financial markets result in greater correlations across markets,” Bruno said.
In comparison, looking at Hedge Fund Research Indices (HFRI), a fund weighted index exhibited a 0.76 correlation to the S&P 500, a market neutral index showed a 0.27 correlation and a merger arbitrage index had a 0.53 correlation.
Dan Petersen, Director of Product Management for IndexIQ, explained that the low correlation helped these alternative strategies zig while the equity markets zagged. For example, during the recent 2007 through 2009 financial crisis when the S&P 500 exhibited a negative drawdown of -50.9% at its worst, the fund weighted index declined -21.4%, the market neutral strategy fell -6.5% and the merger arbitrage index dipped -6.6%.
However, potential investors should be aware that these various alternative strategies also follow cycles or perform differently in varying market environments. For instance, the HFRI Yield Alternative Index was among the best performing alternative strategies in 2016 but the same index was also the worst performing in 2017.
Consequently, investors may look at a combined portfolio of the various hedge fund strategies as a way to smooth out the edges. While the HFRI fund-of-funds experienced lower returns than the S&P 500 in periods of strength for the stock markets, the fund-of-funds alternative strategy has exhibited lower drawdowns in down periods and shown more attractive return-per-unit of risk or better Sharpe ratios in equity up markets. The alt strategy is characterized as “attractive Sharpe when wanted, less negative impact when needed,” Petersen added.
While the average retail investor and advisor may not directly access HFRI fund-of-funds index, one may look to something like the IQ Hedge Multi-Strategy ETF (NYSEArca: QAI), which exhibits similar diversification characteristics as the HFRI benchmark.
“HFRI FOF Index can be seen as a close version of beta to hedge funds,” Bruno said.
QAI is the largest alternative strategy ETF on the market and provides a diversified mix of alternative strategies, including multiple hedge fund investment styles, such as long/short equity, global macro, market neutral, event-driven, fixed income arbitrage and emerging market hedge.
Financial advisors who are interested in learning more about alternative strategies can watch the webcast here on demand.