How Do Alternative Investments Perform in a Rising Interest Rate Environment?

How Do Alternative Investments Perform in a Rising Interest Rate Environment?

The proliferation of liquid alternative mutual funds happened in response to the 2008-2009 recession, which was followed by an extended period of unusually low interest rates.

The December 2016 rate hike by the Fed was just the second in a decade. Now that the economy is believed to be in growth mode, the Fed appears to be committed to a series of rate increases including the possibility of a hike today.

Equities have historically performed well when the economy is growing, justifying steadily rising rates. But what do we know about alternative funds? How do liquid alts perform when rates are rising?

The Transition to Rising Rates

Whether traditional or alternative, equity or fixed income investments are subject to the same market conditions. Below we look at market performance during eight rising rate periods over 15 years. Although each period has its own characteristics, the following typically applies to the transition to a rising rate period:

  • Increased market volatility typically accompanies a regime change, as capital shifts to investments expected to benefit from a monetary tightening cycle. For example, capital moves from high-dividend paying investments (utilities, REITS, high-dividend stocks) to sectors that may benefit from economic growth and higher interest rates (technology and financials). This generally favors investors focused on equity solutions.
  • Just as rate-sensitive sectors are often negatively affected, rising rates can be a challenge for fixed income investments. However, as new bonds come to the market priced at higher interest rates, yields can become more attractive to income-seekers.
  • During periods of rising rates, it may be advantageous to diversify into non-U.S. markets, as valuations historically have been more attractive relative to U.S. equities.

Alternative Funds When Rates Rise

First let’s compare an alternatives category proxy (Wilshire Liquid Alternative TR USD) to a broad equity (Standard & Poor’s 500) and fixed income (Bloomberg Barclays U.S. Aggregate Bond) index.

No surprise here—growth helps drive corporate returns and generally stock prices, while rising rates can pose challenges for fixed income as a whole. Performance by alternative funds, as you can see, was middling—better than fixed income but not as strong as equities.